Is it safe to invest in liquid funds?

Rating downgrades by the rating agencies one after the other, has caught the investors by shock. The situation is even worse for the investors in liquid funds. What if an investor parks a large amount of money for a mere 7 days in a liquid fund and the very next day the NAV of the scheme falls by 6-7% odd percent? I am pretty much sure that it will not be less than any bombshell on that investor.

Let us first understand what are liquid funds and where do these invest and then we will head to whether you should invest in liquid funds or not. Liquid funds are those mutual fund schemes that invest in debt and money market securities with maturity of not more than 91 days. These schemes were considered to be the safest schemes but due to the recent situations in the past where we have seen a sequence of defaults and downgrades of some papers has developed a panic like situation among the investors.

MAJOR CHANGES IN THE RISK MANAGEMENT FRAMEWORK OF LIQUID FUNDS ORDERED AND PRESCRIBED BY SEBI

  1.  Liquid funds will now have to hold at least 20% of its assets in the form of cash, T- bills and repo on government securities.
  2. The sectoral limit has been reduced to 20% from earlier 25%. The additional exposure of 15% to housing finance companies has now been bifurcated into two parts – 10% to securitized debt based on retail housing loan and 5% to affordable housing loan portfolio.
  3. Liquid funds will not be allowed to invest in short term debt and money market instruments having structured obligations or credit enhancements.
  4. A graded exit load will be imposed on the investors for a period of up to 7 days if the investments are redeemed before the said period. This will help in avoiding lumpy inflow and outflow from the liquid funds.
  5. The market regulator SEBI, has instructed all the AMCs to value all the holdings in a liquid mutual fund scheme on mark to market basis (i.e. value underlying securities at existing market prices). Earlier the liquid funds were supposed to value only holdings with maturities of more than 60 days on mark to market basis while the bonds with maturity of up to 6o days were used to be valued only on amortization basis. Now, SEBI has done away with the entire amortization thing.
    The NAVs of the liquid funds are set to become more realistic with these measures and will be slightly more volatile (not wildly).

SHOULD YOU SHIFT TOWARDS OVERNIGHT FUNDS (a new category of debt mutual funds for parking money idle money)

SEBI has introduced a new category of mutual funds known as overnight funds. These funds will only hold securities which mature in one day and have to reinvest its corpus every other day. This make these funds the most secured debt schemes as there is hardly any interest rate risk and also these schemes are not vulnerable to any kind of credit risk as the underlying securities are backed by collateral.

But does shifting your current investment in liquid funds to overnight funds really make sense? Not really. Until and unless you want to park your funds for less than 7 days and want to take negligible risk, shifting your funds to overnight funds is not worth the exercise.

The reason being that liquid funds will now value its underlying securities having maturity of more than 30 days (earlier 60 days) on mark to market basis which will make them more transparent than ever before. Also, the overnight funds generate low returns if we compare it to the returns of liquid funds as they hold securities which mature in 1 day while liquid funds invest in securities with up to 91 days maturity. The investors should not stop investing in liquid mutual funds just because of downgrades and defaults by some papers as these were specific to few schemes only which hold a very modest share in terms of total AUM of the industry.

Hence it does not make any sense in welcoming and accepting lower returns on your investments if your risk appetite permits you to stay invested in liquid funds with a little volatility (almost negligible) but even if you want to get away with this slightest risk then you may consider shifting your funds to overnight mutual fund schemes.

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