Mark-to-mar­ket pro­file needed for liq­uid funds

Mint Asia ST - - Money - ARVIND CHARI

In June 2012, Sebi came out with two po­lices of pre­scrip­tive na­ture for mu­tual funds—one was on ad­ver­tis­ing guide­lines and the other on fair val­u­a­tion of se­cu­ri­ties. Debt funds usu­ally need guid­ance on how to value their se­cu­ri­ties as debt se­cu­ri­ties are typ­i­cally not much traded un­like listed eq­uity shares. The chal­lenge is how to mea­sure them fairly. Sebi laid down a board frame­work on the “spirit” of the pol­icy and ad­vised as­set man­age­ment com­pa­nies (AMCS) to have an in­ter­nal fair val­u­a­tion pol­icy based on the “prin­ci­ples” and have it ap­proved by the Mu­tual Funds Board of Trus­tees.

It was in­deed a much-needed move to bring in trans­parency, ra­tio­nal­ity and ob­jec­tiv­ity to the way mu­tual funds can value their port­fo­lio hold­ings and that the daily de­clared NAV (net as­set value) is as close to the re­al­is­able value of those un­der­ly­ing se­cu­ri­ties if one had to liq­ui­date those as­sets in the mar­ket.

Be­ing a prin­ci­ple-based pol­icy as against a pre­scrip­tive pol­icy also puts the onus on the AMC to frame in­ter­nal poli­cies that will meet with the spirit of the guide­line as the regulator re­tained the over-rid­ing right of in­ter­pret­ing and ques­tion­ing fair val­u­a­tion.

In­dian eq­ui­ties were easy to value as a ma­jor­ity of wide­ly­held se­cu­ri­ties are traded and quoted on the stock ex­change and “Bhav Copy” (a newslet­ter that com­piles the stock prices of all listed se­cu­ri­ties) be­comes a rea­son­ably good mea­sure of in­dus­try-wide com­mon val­u­a­tion source.

In­dian bonds though were tricky. Gov­ern­ment bonds trade on screen and those that don’t have other sources of mark-to-model pric­ing by agen­cies like Clear­ing Corp. of In­dia Ltd and Fixed In­come and Money Mar­ket Deal­ers As­so­ci­a­tion. In­dian cor­po­rate bonds don’t trade on screen and a very small per­cent­age of the over­all out­stand­ing gets traded and re­ported on the ex­change. Till June 2012, cor­po­rate bonds were val­ued based on in­ter­nal poli­cies with some help from ex­ter­nal valu­ing agen­cies. With Sebi get­ting stricter, and AMCS not want­ing to take up the onus of de­ter­min­ing fair val­u­a­tion; they found a com­mon in­dus­try-wide sim­i­lar val­u­a­tion prac­tice by ap­point­ing en­ti­ties of Crisil and ICRA to pro­vide daily val­u­a­tion for all debt in­stru­ments. Since 2012, Crisil and ICRA have been pro­vid­ing the fair (traded) prices of all se­cu­ri­ties to all fund houses, which are re­quired to use the list to value hold­ings and then come up with debt schemes’ NAVS.

This was a good out­come as bonds would now be val­ued by an ex­ter­nal and in­de­pen­dent agency and each bond would have a com­mon price across all fund houses. This was a good out­come also be­cause prior to this, there may have been in­stances of one bond be­ing val­ued at two dif­fer­ent prices by the same fund house in two dif­fer­ent schemes. The in­dus­try has come a long way since then on the is­sue of fair val­u­a­tion but for one par­tic­u­lar as­pect.

Even now, Crisil and ICRA daily list of se­cu­ri­ties and their fair prices per­tain to se­cu­ri­ties that are 60 or more days old. Bond in­stru­ments ma­tur­ing in less than 60 days are not “fairly val­ued”. The in­dus­try then had ar­gued that liq­uid funds which typ­i­cally in­vest in less than 90-day in­stru­ments, if moved to daily mark-to-mar­ket on fair val­u­a­tion, would pro­vide “volatile” re­turns which may not be palat­able to large in­sti­tu­tional in­vestors who in­vest their cash sur­plus in these. They said that those in­vestors will move to in­vest­ing in bank FDS and MFS will lose out. So if a fund house owns any in­stru­ment which has a ma­tu­rity be­low 60 days, it can choose to not mark-to-mar­ket it daily, re­sult­ing in a sit­u­a­tion where the mar­ket price of the in­stru­ment could be at odds with the price at which the NAV was cal­cu­lated.

Take ex­am­ples of de­faults in liq­uid funds in the last three years. In most cases, they have been in in­stru­ments with less than 60 days’ ma­tu­rity. So, it could have so hap­pened that fund houses have been valu­ing that pa­per at an “ar­ti­fi­cially” high price not recog­nis­ing the ac­tual mar­ket value of that bond prior to de­fault. Thus, most funds took large hits on the day of de­fault or a down­grade by rat­ing agen­cies as against al­ready ac­count­ing for some ero­sion in value, if they were aware of it.

Sebi should man­date all in­stru­ments to be com­pul­so­rily marked-to-mar­ket with­out ex­cep­tion. Liq­uid funds or, for that mat­ter, any bond funds are not fixed de­posits. The re­turns of these funds are not and should not re­main lin­ear. I be­lieve, Sebi in their pol­icy blue­print would have de­cided to move all in­stru­ments to fair val­u­a­tion at some point in time. That time has come.

Arvind Chari is head, fixed in­come and al­ter­na­tives, at Quan­tum Ad­vi­sors.

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