Do The New Valuation Norms For Debt Mutual Funds Affect Your Investments?
Mar 27, 2019

Author: PersonalFN Content & Research Team

(Image source: freepik.com)

Until now, if non-traded money market and debt securities, including floating rate instruments, had a residual maturity of 60 days or less, the Mark-To-Market (M-T-M) norms were inapplicable.

However, valuation norms for debt securities have changed recently. According to the SEBI circular dated 22 March 2019, only securities with a residual maturity of 30 days or less will see relaxation from M-T-M valuation norms.

Now mutual fund houses will have to comply with these norms within the next 90 days, i.e. by 20 June, 2019.

With these amendments in the rules, SEBI intends to make portfolio valuations of debt funds more reflective of a realisable value.

Change in valuation norms for below-investment grade securities

Moreover, the capital market regulator has also amended the norms governing the valuation of below-investment grade securities.

Mutual funds will have to take the price valuation agencies provide to arrive at the value of below-investment grade securities to calculate Net Asset Value (NAV).

Until valuation agencies come up with their valuations, mutual funds should value such investments after taking into account indicative haircuts estimated by the agencies. The said haircuts will become applicable from the day rating agencies slashed the rating (credit event) of a security to below-investment grade.

Further, if the security is traded in the interim, i.e. from the day of the credit event and day of the agency providing the valuation, mutual fund houses will consider the traded price for the valuation, if it's lower than the price adjusted for the indicative haircut.

Conversely, if the traded price is higher than what the valuation agency has provided, mutual fund houses will consider such a price and the valuation price will be revised upwards.

SEBI has allowed mutual funds to deviate from the post-haircut price and valuation price the valuation agency has provided on condition that the scheme explains the rationale for such deviation in a detailed manner. Else, the valuation price provided by the valuation agency will prevail.

The capital market regulator has given valuation agencies time till 20^th June, 2019 to develop systems required to value below-investment grade securities.

How will this impact mutual funds?

The most positive impact: NAVs of debt and money market mutual funds will be more realistic and transparent ---they will reflect changes in the credit quality. This would affect the performance of fund houses, which have been hiding behind the regulatory loopholes and were valuing non-standard and illiquid assets upto 60 days residual maturity at unrealisable valuations.

In the wake of changing regulations, mutual funds will become more disciplined and consistent about the credit quality of the portfolio. Otherwise, it will now immediately reflect in their performance.

What's the impact on investors?

Going by the recent experiences, when short-term debt funds and money market mutual funds hold securities of troubled companies which are either in for a credit event or are on the brink of defaulting their payment, investors suffer heavy loses. In fact, a percent of loss in the money market mutual fund is severe, considering it's a high-ticket investment product.

When there's a credit event or when the security simply has no liqduity with respect to a few securities in the portfolio, mutual fund schemes end up selling even liquid and highly rated securities to keep up with redemption pressure.

This results in even bigger losses for investors. At the end of these processes, the overall portfolio quality of the mutual fund scheme deteriorates further.

The change in valuation norms will help resolve this issue largely, as there will be an indicative valuation even for the troubled securities.

So if IL&FS and DHFL episodes reoccur in the future, mutual funds won't be able to keep investors in the dark.

That said, at the time of investment, mutual funds rarely prefer below-investment grade securities.

Please keep this in mind while investing in debt funds:

Investing in debt funds isn't risk-free.
You shouldn't invest in schemes only because they have outperformed their benchmarks in the recent past.
You should consider your financial goals, risk appetite, and time horizon before investing in any debt-oriented scheme.
Following your personalised asset allocation is the key.
Ideally, you should invest only in schemes that have a maturity profile in sync with your time horizon to avoid unpleasant surprises.
Invest only in debt schemes offered by mutual fund houses that follow robust investment processes and have adequate risk management systems in place.

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