Why Liquid Funds & Money Market Funds Are Falling?

Liquid Funds & Money Market Funds Hit By Rising Yields

Introduction

Why Liquid Funds & Money Market Funds are falling since last one week ? The liquid funds and money market funds have encountered a painful situation amidst recent equity and bond market sell-offs by FIIs. Both the categories took a hit since their last 1-day, 3-day and 1-week returns turned negative.

Why Liquid Funds & Money Market Funds Are Falling?

Sharp Rise in Bond Yields

• Earlier in the last week, the short-term, medium-term and long-term segments of debt mutual funds have given negative weekly returns due to a sharp rise in the bond yields. The same has now affected liquid and money market segments also. Only overnight funds have so far been spared.
• The yields in the debt market have risen due to COVID-19 driven selling by FIIs. There were other two reasons also for the rise in bond yields.
  • Investors prefer to hold more cash at year end and that requirement has gone up due to the current volatility.
  • Stay-at-home and organisational disruption has reduced dealer presence in the market

Effect of Subdued Demand in the Bond Market

• Amidst an imminent economic crisis, the demand in the bond market has suddenly gone down as institutional investors sold off their positions.
• With a sudden drop in demand, the bond prices dropped. This resulted in a fall in NAV (Net Asset Value) of the fund.

How Do Bond Prices & Yields in Debt Funds Work?

• Market demand and supply is measured with the Bond yield, where
• Bond yield = (Interest Income/ Current Bond Price)
• From this definition, it is clear that bond prices and yields must move in opposite directions. Thus, when bond prices fall, the bond yield shoots up and vice versa.
• Short-term bonds are less prone to price and yield changes because they are not far from maturity, at which time their prices will coincide with their face values.
• Longer the duration of the bond more will be the fall in bond price with falling demand, more will be the increase in yield, more will be the fall in NAV of that debt fund.
• It does not matter if the bond is gilt or AAA-rated or A1+ rated. A sudden mismatch of sellers and buyers (where, sellers > buyers) will lead to a fall in the fund’s NAV.

RBI’s Intervention to Boost Market Liquidity

• The Reserve Bank of India enhanced the market liquidity with an additional bond purchase for as much as Rs.10,000 crore.
• The RBI has stepped in by buying Rs.10,000 Crore of bonds to create demand (and therefore bond yields) in the market on 18th March. This has restricted the further increase in yield to some extent.
• It was mostly in short term notes as it looks to oil the corporate bonds and the Commercial Paper markets which have seen a spike in yields and falling volumes due to risk aversion.

Effect on Rise in Yields on Debt Funds

1. Short-term, Medium-term & Long-term Debt Funds

• We have seen above a jump in yields causes prices of bonds to fall and hence, debt funds to suffer. Due to the same reason, the short-term, medium-term and long-term segments of debt mutual funds have given negative weekly returns in the last week.
• The six-month gilt yield was 4.78% on 16th Mar. It shot up to 4.92% on 17th, 5.08% on the 18th, 5.15% on the 19th. The increased has slowed down but it is still an increase and therefore money market funds were not spared.
• The three-month gilt yield was 4.73% on 16th Mar. It shot up to 4.80% on 17th, 4.88% on the 18th, 4.87% on the 19th. RBI’s action has made a better impact in this segment but was not enough to prevent a fall in liquid fund NAV. The situation should be better in the coming days. 
• RBI is likely to go slow in regard to interest rate cut with already low demand as it could cause more trouble for debt mutual fund investors.
• A drop in interest rates is unlikely to improve the mood in the market immediately. It would only result in provoking the common man.

2. Liquid Funds & Money Market Funds

• Unlike the short, medium and long duration debt funds, debt funds at the short end of the spectrum such as Liquid or Money Market Funds or Ultra short funds are not considered to be very sensitive to such shocks.
• This is on account of the short maturity of the paper they hold. The past week has seen this assumption challenged with these categories also taking a hit.
• On an average, liquid funds have delivered 0% over the past week and many large liquid funds have actually delivered negative return. While, Money market funds have given -0.51%.
• These are categories that normally do not deliver negative returns, even over short time periods and are considered extremely low risk.

Absolute Change in NAV of Liquid & Money Market Funds & Benchmarks

The 1-day (19-20 March), 3-day (17-20 March) and 1-week absolute change in NAV of liquid and money market funds along with relevant indices is shown below.

What Investors Should Do?

• RBI’s upcoming intervention in the debt market is expected to bring down the yields soon.
• Investors need not switch from liquid or money market funds to overnight for any time horizon more than a week.
  • The average yield difference between overnight and liquid funds is about 1.5%.
  • So anyone with a horizon of 30 days or more would be equal or better off in liquid funds even if yields rise by up to 3%, assuming 45 days liquid fund duration.
  • Since a 3% jump in yields is an extremely rare occurrence, investors will be better off in liquid funds.
• Investors should not panic excessively from this very rare occurrence in the debt market (negative returns for Liquid and Money market funds).
• If your time horizon is less than 1 week, you can look at overnight funds. This is because liquid funds have an exit load for periods up to 7 days from the date of investment.
• The situation in the short-term segment of the bond market should stabilize soon. A few days of negative returns are possible now and then.
• So investors can continue to hold money market and liquid funds with the short-term negative impact on the returns.

Here is a video explaining – How Bond Market Works?