Recent IL&FS credit event rocked the NAVs of least four liquid funds. So far, liquid funds were considered to be the safest investment option in the mutual fund basket. Thus, investors seeking safety did not view the volatility favourably.
In addition, SEBI too has been mulling over tougher rules for liquid funds to better capture their underlying risk. Currently, fund houses have to do mark-to-market valuations of securities having maturity more than 60 days. While liquid funds are permitted to hold securities up to 91 days, most invest in instruments having maturity below 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.
Reports suggest that SEBI is planning to ask fund houses to do mark to market valuation of debt instrument having maturity of less 60 days. Debt market analysts feel that doing mark-to-market valuations of all securities on a daily basis would increase the volatility in these funds. Consequently, liquid funds would start reflecting negative returns frequently.
Moreover, liquid funds have a degree of leeway in terms of credit investments. However, most MFs chose not to take undue risk by investing in lower rated instruments.
Investors who want complete peace of mind can look at funds, which offer a safer proposition in terms of credit risk and interest rate risk.
One such option is liquid ETF. Liquid ETFs invest at least 95% of their assets in tri-party repo (TREPS). The remaining 5% can be invested in other money market and debt securities.
Tri-party repo (TREPS) is a type of repo contract where a third entity (apart from the borrower and lender), called a tri-party agent, acts as an intermediary between the two parties to the repo to facilitate services like collateral selection, payment and settlement, custody and management during the life of the transaction. TREPS have replaced CBLO post October.
How are these funds safer on the interest rate risk front?
Majority of the investments in these funds happen in the overnight space in TREPS. These investments are renewed daily. This limits any impact on price of investments due to mark to market movement. While there is a risk of re-investing the principal at a lower rate, essentially investor’s principal is secured.
Anil Ghelani, Senior VP, Head of Passive Investments and Products at DSP MF shared that while the market has tri-party repos (TREPS) of higher maturities, typically the overnight segment is the most liquid and majority of trades happen in that space. Consequently, these funds have average maturity of just a few days.
How are these funds safer on the credit risk front?
In addition, all investments tri party repos are made through CCIL, an exchange platform. CCIL requires the borrower to deposit sufficient collateral in terms of highly rated debt securities to cover for the loan. So, in case of default by the borrower, the exchange can sell off the collateral to settle the trade. Thus, these funds carry negligible credit risk as majority of the portfolio is invested in exchange backed TREPS.
These schemes were designed as a hassle-free investment option for equity traders to park their idle funds. However, investors who do not want to take much mark to market and credit risk can also invest in these funds.
Currently, there are only two liquid ETF schemes (DSP Liquid ETF and Reliance ETF Liquid BeES) in the market.
