Thursday, November 13, 2008


Panic redemptions and tight money have resulted in liquid funds declaring losses for the first time in many years. But is there a way out? 

If you think that liquid funds are absolutely safe and protect your capital at all times, then think again. On 8 October, three liquid plus funds, Mirae Asset Liquid Plus (MALP), DSP Merrill Lynch Liquid Plus and Templeton India Ultra Short Bond funds gave one-day negative returns. MALP was the worst hit as it lost 0.40 per cent that day. While a day’s loss may not sound catastrophic in any other funds, in the case of liquid funds it grabs headlines because many large investors and companies park their surplus cash in these funds for a day or a week or a fortnight. To make matters worse, some schemes limited redemptions. On 15 October, ABN Amro MF limited redemptions on few of its fixed maturity plans (FMP) to Rs one lakh per folio. What went wrong?  

Bad assets…

After a series of media reports about the illiquidity of the underlying assets in which many liquid, liquid-plus and especially fixed maturity plans (FMP) had invested in and their questionable credit quality, large investors who were already facing tough times and a cash crunch began withdrawing money from these schemes. Soaring short-term bank fixed deposit (FD) rates did not help MFs, as these investors started pulling money out from these schemes and invest in bank FDs.

In this melee, not just the culprit FMPs but even those that had comparatively cleaner portfolios were also affected. As a result, many investors who withdrew from FMPs made a loss on their investments because they did not get the indicative yield they were told – albeit unofficially, as MFs are not allowed to assure returns - as they withdrew much before the scheme’s maturity. MFs arrive at indicative yields based on the assumption that investors will stay till maturity. But such yields go for a toss when MFs have to make a distress sale to generate cash to meet redemptions. Add to them the exit loads that most FMPs impose on pre-mature withdrawals, and investors who got out last month most likely made a loss.

Whilst Outlook Money was amongst the first ones to warn readers of such assets in which many FMPs had invested in (See, ‘Are Fixed Maturity Plans A Ticking Time Bomb’, 10 September 2008), the rot runs much deeper.  

In addition to investing in illiquid real-asset papers, many liquid and liquid-plus funds have also invested in instruments called pass-through certificates (PTC). These are essentially loans issued by banks to borrowers that are then bundled off as securities and sold off to buyers such as mutual funds. Assume a bank issues a five-year loan XZY at an interest rate of 10 per cent. Since it would take five years for this bank to recover the loan, it sells off this loan to, say, a mutual fund, at say, seven per cent. The bank would earn the spread (difference in interest rates) of three per cent (10 per cent – seven per cent). The MF would pay the lumpsum to the bank, who in-turn would get back the principal amount (that it had originally lent to XYZ company) upfront; interest payments that XYZ company would keep paying to the bank, in the meantime, would be forwarded (after deducting the spread) to the MF. 

PTCs can be quite toxic if the loan originator (XYZ company in the case, above) is a low-rated one. MF sources say that even if the original borrower is a top-rated company, there are no buyers these days in the markets for PTCs that MFs may want to sell, to raise cash to meet redemptions. On account of a slow economic growth and poor result forecasts, there seems to be a perception about the companies’ ability to repay loans. Hence, PTCs are pretty illiquid these days. 

As per the September-end portfolio of liquid and liquid-plus, some schemes have invested significant chunks in PTCs. There’s little transparency here, as in the absence of the regulator’s mandate, most MFs do not publish details of these PTCs. ICICI Prudential MF was the first, and till date the only MF, that publishes details of its PTC investments. Not just the PTCs, but some short-term funds, including FMPs, suffer from poor credit quality. The problem is compounded here since most FMPs do not disclose their portfolios regularly. 

Funds, especially liquid-plus funds (liquid-type funds that have a mark-to-market portfolio component of more than 10 per cent; their maturities are therefore higher than liquid funds) with longer maturities got hit too; it’s harder to find buyers for longer-dated securities when liquidity is tight. 

…Low liquidity
The problem of the rush on redemptions was compounded by the lack of liquidity in the system on account of several reasons that had resulted in banks also withdrawing their funds from liquid and liquid-plus funds earlier. The rush on redemptions compelled liquid funds to sell their most liquid assets at throw-away prices that resulted in their losses. Fund sources say that although Sebi allows MFs to borrow up to 20 per cent of their corpus from banks to meet redemption pressures, money wasn’t available.

Even fixed maturity plans (FMP) saw a rush on redemptions on the back of news reports of bad assets held by them. Although the October-end corpus figures are yet to be disclosed, market reports suggest that liquid and liquid-plus funds have already seen redemptions of around Rs 50,000 crore in October.

Regulatory help
On 14 October, the reserve bank of India (RBI) allowed MFs to take loans from banks to meet their redemption proceeds by directly pledging their certificate of deposits (CDs; these are one of the short-term and liquid instruments that debt funds invest in) for a period of 15 days. This was a reversal of an earlier RBI stand wherein banks were not allowed to grant loans against CDs and were also not allowed to buy-back their own CDs before maturity.

But this measure seems to have come a little late, because out of Rs 20,000 crore that’s been made available to funds, MFs have utilised only Rs 8,800 crore up till 24 October. “Since the panic redemptions had already landed up on MF’s doorstep before RBI came out with his rule, MFs had already sold most of the CDs by then”, says Ashish Nigam, Head-fixed income, Religare Aegon mutual fund. Later, on 18 October, Sebi eased the guidelines for valuing debt securities too.

What should you do?
Understand that even if liquid funds are less risky than other MF schemes, they still carry risk. No MF is risk-free. Though liquid funds are not volatile to the interest rate scenario because their assets are not marked-to-market (Sebi mandates only instruments more than six months maturity to be marked-to-market; liquid funds hold scrips with a less than six months maturity), they do turn volatile at times. Liquid funds have to mark-to-market their instruments when they sell them and then book a profit or a loss at that time. And if there’s a liquidity crunch or a huge redemption pressure - like the one we’ve seen so far in October – they could be forced to sell instruments at panic prices, resulting in a loss, even if the scrips being sold are of a good quality, like Mirae Liquid Funds’. Despite having a high-quality portfolio (highest credit rating, no PTCs and only CDs), Mirae schemes incurred losses.

MFs also have a clause in their offer documents to initiate stagger payments in case of panic redemptions and thereby its inability to generate enough cash to meet the redemptions. ABN Amro MF merely used this provision in its FMPs at the time of redeeming them.

Look at average maturity
But there are a few things that you could look at, such as the average maturity of your liquid funds. The lower the maturity, the safer is your fund, because scrips of lower maturity are easier to sell and are also less volatile, compared to those with higher maturity. Funds with lower maturities are conservative and give lesser returns than those with higher maturities, but in volatile times, their downside is limited.

Stick to larger liquid funds, preferably, with a corpus size of more than Rs 1,000 crore. Although panic redemptions in times like these hit almost all funds, the larger ones are comparatively less hit. Even a few large investors who withdraw from small-sized liquid funds can leave a much bigger impact.

Credit quality
Credit quality. Check out your liquid fund’s credit quality. Monthly portfolios of existing
schemes (if you are investing in liquid and liquid-plus schemes) are available on the MF’s website. Else, tell your broker to get you a monthly factsheet and have him take you through the portfolio’s credit quality if you are unable to decipher these details yourself.

Avoid schemes that have a large holding in assets below a AA or an equivalent credit rating (OLM’s threshold; see table 2) or in PTCs. “The lower your liquid funds’ portfolio quality, the harder it is for them to sell their scrips to fund redemptions”, adds Amit Trivedi, Proprietor, Karmayog Knowledge Academy, an MF training institute. If you are investing in FMPs, make sure you read the offer document. Some FMPs explicitly say in the offer documents that they will avoid low-rated scrips. Look out for any such portfolio credit-quality related statements in the offer document while choosing.

Stay invested in FMPs
Assuming you have already invested in an FMP belonging to a well-pedigreed fund house, do not panic. When FMPs give you an indicative yield you’re most likely to earn, they arrive at these calculations assuming that you’d stay invested till maturity. But when faced with panic redemptions, especially in times like these when buyers are few and far between, FMPs are forced to sell their scrips in a hurry and at throwaway prices. This negatively impacts your yield and you are most likely to incur a loss, especially since exit loads are levied for premature withdrawals.

For fresh investments, stick to well-pedigreed FMP and only if you are willing to stick around till maturity. Infact news reports indicate that Sebi is contemplating banning early withdrawals from FMPs. “Fixed income segment still remains attractive. But don’t get greedy and avoid going for FMPs that necessarily give higher indicative yields. Look at safety and consistent returns”, adds Nigam.

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