Explainer on the recent changes in the valuation of securites held by Liquid Funds

SEBI recently made a change on how AMCs have to value the securities they hold. Liquid funds can only hold securities with a maximum residual maturity of 91 days. Earlier, any security with a residual maturity of 60 days was not required to be marked to market. They were valued on an amortization basis. If a security had a residual maturity of more than 60 days, it was required to be marked to market.

So, the reason why all Liquid Funds have straight line returns is because of 2 reasons

  1. AMCs mostly stuck to papers with residual maturity of less than 60 days.
  2. Because they were investing very little in papers above 60 days they didn’t have to mark the papers to market which meant no fluctuations in the NAV, which kind of gave investors a false sense of comfort.

Oh, under amortization, a fund calculates the value of the security based on the interest accrued and doesn’t mark the security to market.

Now, after the recent change, SEBI has said that securities with residual maturity of more than 30 days will have to be marked to market. Theoretically, this means that the Liquid Fund NAVs will become more volatile, especially during credit events such as IL&FS and liquidity crunches like the DHFL saga.

But not so fast, here’s an interesting view by Arvind Chari, head of fixed income at Quantum Advisors on why this move by SEBI is incomplete and how AMCs can get around the headache of valuing securities on an M2M basis.