Regulatory Changes by SEBI in Liquid, Overnight Debt Funds During FY2019-20

SEBI Circular – Changes in Debt Funds applicable in FY 2019-20

Introduction

SEBI (Securities and Exchange Board of India) has improved some fund management regulation for liquid, overnight debt funds. As per SEBI circular issued on 20th September 2019, the recent changes in Debt funds categories are discussed in this article.

SEBI Circular – Recent Regulatory Changes in Debt Funds Categories

• Keeping in mind the recent credit events in fixed income market that led to increase in liquidity risk of Mutual Funds, it was needful to review the regulatory framework and take necessary steps :
  1. To safeguard the interest of investors
  2. To maintain the orderliness and robustness in mutual funds
• Given the background, The Securities and Exchange Board of India (SEBI) has come up with a Review of Risk Management Framework of Liquid Funds, Investment Norms and Valuation of Money Market and Debt Securities by Mutual Fund.

Regulatory Changes in Liquid, Overnight Debt Funds During FY2019-20 as per SEBI Circular

Highlights of SEBI Circular – Here are the changes proposed by SEBI:

1. Liquid funds shall hold at least 20% of its corpus in liquid assets w.e.f. April 1, 2020

• Liquid Schemes shall hold at least 20% of its corpus in Highly liquid assets such as Cash, Government Securities, T-bills and Repo on Government Securities.
• If in case the exposure in these liquid assets falls below 20%, the AMC shall insure compliance before making any further investments.

2. Graded exit load shall be levied on investors of liquid schemes

• A graded exit load shall be levied on investors of liquid schemes who exit the scheme within a period of 7 days of their investment. Graded exit load roughly means the load will be reduced with each passing day up to 7 days.
• Therefore, investors redeeming on second day will have to pay more exit load than investors redeeming on seventh day. The move is a positive for retail investors as it lowers the chances of volatility caused by big flows in liquid fund returns.
• Institutional investors on the other hand have Overnight funds as an immediate substitute to Liquid Funds.

• The percentages though look small in absolute terms but are much significant when compared with the returns of liquid funds in very short period of time.
  • Example : An investment of Rs. 1 crore in liquid fund would fetch around 7%p.a. pretax returns i.e. Rs. 7 lakh. Which is about Rs. 1918 per day. An exit load of Rs.700 (Rs. 1 Cr x 0.007%) would eat almost 36% of the returns(pretax).

3. Liquid Funds shall not park funds in short term deposits of banks

• According to this regulation, Liquid Funds and Overnight Funds shall not park funds pending deployment in short term deposits of scheduled commercial banks.
• In simple words they shall not invest in bank FD’s.

4. Liquid Funds shall not invest in debt securities having SO and/or CE ratings

• Liquid and overnight schemes shall not be permitted to invest in debt securities having Structured Obligations (SO ratings) and/or Credit Enhancements (CE ratings). However they can invest in debt securities with government guarantee.
• What is Credit Enhancement?
  • Suppose a company wants to raise capital by issuing a bond. Now, it may use some external Credit enhancement to lower the interest rate it has to pay to investors.
  • For this it can get a Bank guarantee assuring investors of the repayment or it can even offer additional collateral. This assurance improves rating of company’s bonds which enables it to raise capital at lower interest rates than what it could get otherwise.
• What is Structured Obligation?
  • A structured obligation is a hybrid debt obligation that shall have a derivative component attached to the underlying bond.
  • This will improve its rating by adjusting the risk return profile of the bond. The returns of a structured obligation shall be based on combined performance of underlying bond and the derivative embedded to it.

5. Cut-off timings for applicability of Net Asset value (NAV)

The cut-off timings for applicability of Net Asset value (NAV) in respect of purchase of units in Liquid and Overnight funds shall be 1.30 pm instead of 2.00 pm earlier.

6. Improving transparency in fees levied by fund houses

From 19th October 2019 the Asset Management Companies (AMCs) shall not be permitted to charge Investment management and Advisory fees for parking of funds in short term deposits of scheduled commercial banks (Bank FD’s). This is a move towards improving transparency in fees levied by fund houses.

7. Introduction of Mark-to-Market Valuation Norms

• SEBI has also introduced Mark-to-Market valuation norms for liquid funds. Accordingly, liquid funds will now have to value all securities in their portfolio with a maturity of 30 days or more on a mark to market basis. It was seen that some mutual fund houses were masking the credit risk profile of liquid funds by taking advantage of accrual system of valuation. With SEBI’s new directive fund managers are anticipated to invest in high-quality papers which eventually will lower residual maturity and the instances of outperformance might reduce.
• What is Mark-to-Market valuation?
  • Mark-to-market valuations reflect a security’s Current Market Value. As against the accrual system which accounts for gains that will be realized in the future and isn’t concerned with a security’s current market value. Following accrual system of valuation was one of the main reasons why many liquid funds incurred sudden losses in recent past.
  • Example : A Liquid fund named “X” invested almost 15% of its assets in a zero coupon bond with Rs 1,000 face value for Rs 975 which had a residual maturity of 55 days. Within a week another liquid fund, “Y”, sold the same bond in huge quantity at a discount price of Rs 960 as there weren’t many active buyers for it. Since the bond is now quoted at Rs 960, there was an unrealized loss of Rs 15 for fund “X” too. But, instead of account for this unrealized loss, the liquid fund “X” kept its valuation unchanged assuming that it will be able to redeem the bond at face value on maturity. Later, an independent rating agency slashed credit rating of this bond, following which the price fell further by Rs 50. Fund “X” still didn’t bother to factor in these changes.
  • By now, it had created a speculation of a potential default. This triggered massive redemptions from the liquid fund “X” since everybody knew that fund “X” had 15% of its portfolio weight invested in a bond of troubled company. To provide liquidity to investors, fund “X” had to sell other good securities in its portfolio too. Eventually, the issuer of the bond defaulted and fund “X” incurred massive loss. Had the fund factored those unrealized losses as done in mark to market valuation it would have reduced the extent of its losses.