But of late, liquid funds have been in the news for, surprisingly and unusually, the wrong reasons.

As you must be aware, the subsidiaries of IL&FS defaulted their payment obligations on their outstanding debt lately which caused a massive erosion in the Net Asset Values (NAVs) of some liquid funds. Following this episode, the capital market regulator has been pondering upon introducing some additional prudential norms for them.

[Read: Why Your Money In Liquid Funds Is At Risk]

As reported by the Economic Times dated January 16, 2019, there's been a buzz in the industry that SEBI might direct mutual funds to invest a minimum portion of their assets in government treasuries. It's also anticipated that, the capital market regulator might impose stricter valuation norms and might even impose a minimum lock-in period requirement for investors of liquid funds.

If this becomes a reality, the fundamental principles guiding investments in liquid funds might change.

Following are the suggestions made by the Mutual Fund Advisory Committee (MFAC), appointed by the capital market regulator:

• Liquid funds should have a lock-in period of seven days for liquid funds.

• They should mark-to-market securities with over 30-days of residual maturity.

• Liquid funds should invest at least 15%-20% of their AUM in government treasuries with residual maturity of 91 days.

What are the implications for liquid funds of these suggestions?

Change in the valuation norms:

Liquid funds invest in instruments with less than 91-days of residual maturity. If the recommendations of MFAC are accepted, they will have lesser flexibility in valuing their assets. As a result, their NAV might become more volatile than it usually is. At present, mutual funds are required to mark-to-market securities only if their residual maturity is more than 60 days.

On the other hand, the other direct consequence of the change in the valuation norms would be on portfolio preferences of fund managers. They would be keen to invest in securities with lower than 30 days of maturity, to avoid excess volatility in the NAVs of their funds. As a result, the volumes in the secondary market (for securities with over 30-days of maturity) might fall to some extent.

Mandatory investments in government treasuries

Government treasuries are the most liquid instruments available in the applicable space (residual maturity of less than 91 days). Besides, they are risk-free. This would substantially improve the risk profile of liquid schemes, in general.

Moreover, with a portfolio of 15%-20% government treasuries, liquid funds can access CBLO (Collateralised Borrowing and Lending Obligation) market to meet urgent cash requirement any time necessary.

The collective impact of change in the valuation norms and minimum investment mandate in the government treasury might be felt on the return potential of the liquid funds. Historically, during the periods of constrained liquidity conditions, liquid funds have generated as high as 8% p.a. returns and 6%-7% returns on an average.

Suggestions pertaining to a minimum lock-in period are unlikely to be accepted

According to data published by the Association of Mutual Funds in India (AMFI), 87% of investors of liquid funds are institutional. As on December 31, 2018, liquid funds accounted for approximately 20% of industry's total AUM of Rs 22.9 lakh crore. If the regulator accepts MFAC's recommendations on introducing the 7-day lock-in period, liquid funds would become an unattractive product to institutional investors. This might cause a drain of AUM at the industry level.

Key takeaways for investors…

Although there's no official communication in this regard from the capital market regulator so far, investors might be ready to brace up these potential changes. You, as an investor, should be reasonable with your return expectations from now onwards. Historical data on returns may not be comparable. Suggested changes are fundamental in nature and may affect the way liquid funds operate at present.

If your time horizon is too short, say a week, and your risk appetite is extremely low, investing in overnight funds might work best for you. They are safer than liquid funds. However, if you are fine taking slightly higher credit risk for better yield compared to overnight funds, you may consider a liquid fund. But avoid liquid funds that have a very high exposure to Commercial Papers (issued by private entities).

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