Just like equity funds, liquid funds may become more volatile going forward. A few fund officials told Cafemutual that SEBI has been reportedly considering introducing mark-to-market valuation for all debt securities. This means fund houses may have to do mark-to-market valuation of debt securities having maturity of less than 60 days.
Currently, SEBI rules says that fund houses have to do mark-to-market valuations of securities having maturity of up to 60 days and more. Liquid funds hold securities having maturity of up to 91 days. However, most liquid funds hold securities having maturity of less than 60 days. As a result, post IL&FS crisis, NAVs of only a very few liquid funds witnessed a sharp decline due to mark-to-market loss.
Joydeep Sen, debt market analyst feels that if fund houses have do mark-to-market valuations of all securities on a daily basis, liquid funds would start reflecting negative returns frequently.
A fund official who is on the MFAC committee said that the market regulator is keen on reducing risk and tightening norms governing debt funds. “Following IL&FS default, SEBI wants to reduce risk in debt funds. Allowing mark-to-market valuation of debt securities having maturities of less than 60 days is likely to reduce such risks in future.”
However, a CEO of an emerging fund house has a different opinion. “This would ensure that fund managers would not take undue risks to deliver attractive performance in liquid funds. Most fund managers buy short term corporate bonds which carries high credit default risk. Since short term funds are meant for conservative investors, taking undue risk is against the scheme’s mandate. I believe that introduction of mark-to-market valuation of all short term bonds would encourage fund managers to hold safer papers such as government and PSU bonds.”
Since debt securities are illiquid in nature and not traded like equities, mark-to-market valuation is challenging for fund houses since they have to quote NAV on a daily basis. Hence, most fund houses rely on rating agencies to derive NAV. Often rating agencies look at accrual to value debt securities. Credit rating agencies reflect the rating agencies’ opinion about the credit risk of debt securities based on historical data and some assumptions about the future, which underplays the possibility of default.
In fact, SEBI has recently tightened disclosure norms for credit ratings agencies. Pankaj Pathak, Fund Manager- Fixed Income, Quantum Mutual Fund said, “The sudden multi-notch downgrade of IL&FS is not the only case when role of rating agencies came under question. There have been series of incidents globally when top rated issuers/debt instruments defaulted on their obligations and rating agencies completely failed to give any warning sign. This led to demands for greater transparency on CRAs’ overall rating methodology, rating assumptions, past performance and broader business model.”