Before you rush to invest in the best liquid mutual fund, read this…
At the beginning of 2013, bond yields were on a gradual decline. The Reserve Bank of India (RBI) had embarked on a rate-cutting spree.
The central bank, in a series of rate cuts, reduced the benchmark repo rate by 75 basis points from 8% at the beginning of January 2013, to 7.25% in May 2013. Bond yields dropped and debt investors were rejoicing.
Investors were optimistic, predicting further rate cuts by the central bank.
Towards the end of June 2013, US Federal Reserve chairman Ben Bernanke said the central bank is preparing to scale back its bond buying program if the economic recovery remains on track. This led to a sell-off in emerging market currencies, stocks, and bonds.
FIIs were selling Indian debt stocks by the truckload, which resulted in rising yields and a depreciating rupee.
On July 16, 2013, the RBI decided to step in to squeeze out the excess liquidity from the system. The RBI increased the Marginal Standing Facility (MSF) rate by 200 bps from 8.25% to 10.25% to make it costlier for the banks to borrow and thereby, tighten the liquidity. The Bank Rate increased to 10.25%.
This measure made the banks and the corporates rush to the mutual fund houses to redeem their investments in debt funds, especially liquid funds , ultra short-term funds, and short-term funds. Such a huge redemption by these entities caused a very high supply of these securities, and therefore, a fall in their values.
Though rare, liquid fund investors were sitting on negative returns.
Liquid Funds are low risk but not risk-free
The negative returns on liquid funds and other debt investments came as a shocker to debt mutual fund investors.
Fund houses and distributors aggressively promoted debt funds as an alternative to fixed deposits and other fixed income products. Unfortunately, they failed to highlight the risk. Investors had to learn the hard way.
Liquid funds are a good short-term cash management tool. But, before you add the best liquid funds to your portfolio, it is essential to understand what they are, how they work, and what risks you might be taking.
How do liquid funds work?
Similar to the way you make deposits at the bank, liquid funds invests your money. These funds invest in short-term debt instruments that mature in less than 13 months – that’s the maximum. But on an average, they keep a maturity of less than 90 days. By keeping a short time-frame, these funds attempt to reduce risk.
Though liquid funds are among the lowest-volatility types of investments, they are not entirely risk-free.
Risks of Liquid Mutual Funds
Liquid funds—like all mutual funds—involve investment risk, including the possible loss of principal. Investors should be aware of the risks and potential for losses associated with liquid fund investing.
Investing in liquid mutual funds usually entails less risk—and less reward—than investing in stock mutual funds. Similarly, bank deposits with a fixed interest rate entail a lower risk and less reward than do bond mutual funds.
In the debt market, yields fluctuate and are not guaranteed. As the investments are market linked, the value of the investment can rise or fall.
Interest rate risk
Bond prices are closely linked to interest rates.
Interest rate risk defines the possibility of change in a bond’s price due to a change in prevailing interest rates. Inversely proportionate, when interest rates go up, most bond prices go down. When interest rates go down, bond prices go up. In general, the longer remainder of a bond’s maturity, the higher its duration will be; which leads to its price tending to fluctuate more as interest rates change. As liquid funds invest in low maturity debt investments and money market securities, the interest rate risk is negligible.
Credit risk
Unlike typical bank fixed deposits or savings accounts, liquid mutual funds are not insured; although money market mutual funds invest in high-quality securities and seek to preserve the value of your investment, there is the risk that you could lose money, and there is no guarantee that you will receive the invested capital when you redeem your units.
If a bond issuer is unable to repay the principal or interest on time, the bond is said to be in default. A decline in an issuer’s credit rating, or creditworthiness, will cause the prices of its bonds to decline and the NAV of the liquid fund, which holds the issuer’s bonds, will decline as well.
Just last year, Taurus Liquid Fund reported a 7.2% drop in its NAV on February 22, 2017. A decline of 7% in a day is uncommon in equity schemes.
Taurus Liquid Fund had an exposure of 4.33% to securities of Ballarpur Industries Limited. The credit rating of the securities we downgraded to default status by India Ratings, leading to a massive decline in the value of the security.
Inflation risk
Because of the safety and short-term nature of the underlying investments, liquid fund returns tend to be lower than those of more volatile investments such as typical stock and bond mutual funds, creating the risk that the rate of return may not keep pace with inflation. Inflation risk is the danger that an increase in price levels will undermine the purchasing power of a bond’s fixed interest payments.
The longer a bond’s maturity, the greater its inflation risk. Bond yields often incorporate expectations of inflation, so that investors are compensated for expected inflation risk. If inflation rises by more than expected when the bond was issued, investors will find that the interest and principal returned to them will be worth less than they had anticipated, hence, bond prices will fall, leading to a lower NAV of the mutual fund.
As liquid funds invest in short-term investments, the inflation risk is low.
Who should consider liquid funds?
Liquid funds are appropriate for savers who:
- Have an investment goal with a short time horizon
- Have a low tolerance for volatility, or are looking to diversify with a more conservative investment
- Need the investment to be extremely liquid
While the returns on liquid funds are generally not as high as the return of other fixed income funds, such as income funds, they do seek to provide stability, and can therefore play an important role in your portfolio. Investors can use liquid funds:
- To offset the typically greater volatility of bond and equity investments
- As short-duration investment goals that may be needed in the near term (such as an emergency fund)
- As a temporary holding place for assets while waiting for other investment opportunities to arise
Top Liquid Funds of the past one year
Performance as on February 24, 2018. Returns are absolute
*Standard Deviation indicates Total Risk and Sharpe Ratio measures the Risk-Adjusted Return. They are calculated over 1-Yr period assuming a risk-free rate of 6.1% p.a..
(Source: ACE MF, PersonalFN Research)
*Please note, this table only represents the best performing funds based solely on past returns and is NOT a recommendation. Mutual Fund investments are subject to market risks. Read all scheme related documents carefully. Past performance is not an indicator for future returns. The percentage returns shown are only for indicative purposes.
As seen in the table, some schemes have been able to perform well with low volatility. Hence, when selecting a fund, always pay heed to the risk-adjusted returns.
How to pick the best liquid fund for 2018?
PersonalFN believes, when you invest in debt funds, you should be careful about the safety measures undertaken by the fund. Unfortunately, most investors overlook the risk.
Please keep in mind, liquid funds are not risk free. You should ideally keep away from the funds that invest in debt securities of inferior quality. You should not invest in a liquid scheme solely based on past returns, as certain schemes may have achieved higher returns by taking additional risk.
Before you invest in a liquid fund, take a deeper look at these aspects:
Average Maturity and Modified Duration: The average maturity of the debt mutual fund scheme should be low at around 30-90 days, so that it is less vulnerable to interest rate movements.
The interest rate sensitivity of a bond is measured vide its modified duration.
Modified duration measures the sensitivity spectrum of the bond price is in relation to change in interest rates. It is a vital measure for you to consider because it includes all components of a bond: price, coupon, maturity date, and interest rate to calculate modified duration. Therefore, modified duration can help you recognise that a bond portfolio with high modified duration will have high price volatility. Thus, liquid funds with a lower duration will be lower risk.
Yield-to-maturity (YTM): YTM is nothing but an anticipated rate of return if the bond is held until maturity date. It is also known as redemption yield. It measures the interest income generated by the bonds in the portfolio. YTM takes into account: the current market price, the face value, the interest payment that will fall due on the bond and years left in its maturity. YTM can be used as an approximate measure of the returns that a fund can generate over its average maturity period.
Credit quality: As you may know, debt instruments in India are rated on the basis of their credit worthiness by various credit rating agencies such as CRISIL, CARE, ICRA, amongst others. Bond and debentures carry a credit rating like AAA, AA, and so on. Each rating denotes certain degree of risk involved — for example, AAA rating is the highest credit rating on this chart.
Hence, credit ratings for debt instruments in the portfolio of a debt mutual fund scheme can throw some light on the qualitative aspects as it helps you assess the credit risk. If the portfolio consists of securities with highest credit rating, it implies that the portfolio is less exposed to default risk.
With the rise in the number of downgrades, it is very important to check how risk-averse the fund manager is and whether your risk appetite is in line with the fund, you plan to invest in.
To conclude…
PersonalFN believes, when you invest in debt funds, top priority should be given to the risk management measures set out in the investment processes and systems followed by the fund house. Then, carefully read the investment strategy the fund would adopt to build its portfolio to achieve its investment objectives.
If the scheme's investment objective will not address the financial goal(s) you have envisioned, clearly stay away. This will help you have only the appropriate schemes in your portfolio. Before choosing from liquid, short-term, medium-term, and/or long-term debt funds, take cognisance of your investment horizon.
You should not invest in a debt scheme solely based on past returns. Pay attention to the quality of debt securities held by the scheme.
Must Read:
How To Select Best Liquid Mutual Funds For 2018 And Why You Shouldn't Ignore The Risk
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Editor's note:
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