Liquid funds invest in papers of 91 days maturity and below. Recently, the Securities and Exchange Board of India (Sebi) changed the valuation norms for these funds.
Earlier, they had to use mark-to-market valuation for papers of 60 days and above. Now, they will have to use this valuation approach for papers of 30 days and above.
Mark-to-market valuation means that papers have to be valued in the portfolio according to their valuation in the secondary market. The other method of valuation is the accrual method. Suppose that a paper was purchased at Rs.95 and will pay Rs.100 on maturity. In this case, the paper is valued at Rs.95 initially in the portfolio. The interest rate of Rs.5 is divided by the tenure and this amount is added to the valuation of the paper each day. Thus, the valuation of that paper moves steadily in a straight line and is not affected by swings in valuation in the secondary market.
But, the accrual method of accounting has a downside. The credit risk in the paper gets hidden. Suppose that a fund manager, in his quest for higher returns, has invested in a lower-grade papers. Usually, when credit risk rises in a bond and there is fear of a default, its price plummets. The risk in the paper gets immediately reflected in the NAV of the liquid fund if it is mark-to-market. The fund manager could then try to exit the paper, if he can. Investors will also become aware of the risk in the portfolio faster and could, if they want, exit the fund.
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