NAV is a fund’s per unit market value. In other words, it reflects valuation of a MF unit. However, finding valuation of equity instruments is easier than debt instruments largely due to liquidity.
While the G-Sec and AAA rated debt instruments are liquid and can be valued easily, it is difficult to find valuation of bonds which are not so liquid.
From May 1, among the key changes for the MF industry is the introduction of mark-to-market valuation for all debt securities, irrespective of their maturity. The market regulator has asked fund houses to follow waterfall approach for valuation of money market and debt securities irrespective of their maturity.
Currently, credit rating agencies follow waterfall valuation approach for debt securities having maturity of over 30 days. Under this approach, while rating agencies consider 1-hour trading volume to arrive at valuation of government securities like g-sec and T-bills, they take into account the trading volume of entire day to arrive at valuation of other debt papers like CPs and CDs. Once they arrive at these valuations, they send the weighted average price of these securities along with the last traded price of these securities to a polling team, which has 25 members from various institutions including banks, mutual funds, insurance and pension funds. Based on the poll, rating agencies decide if a security is valued at weighted average price or its last traded price. However, if the security was last traded one month or two months ago, valuation agency looks at market trend and the valuation spread of the security i.e. difference between g-sec yield and yield of the security, somewhat better than accrual-only valuation.
Now with the latest regulations, fund houses will have to follow this approach for securities having maturity of less than 30 days too.
Currently, fund houses broadly follow three metrics to arrive at NAV in a liquid fund
- For a portion of portfolio having exposure to government bonds like g-sec, treasury bills or state development loans (SDLs), the fund house has to rely on credit ratings agencies
- For repo, tri party repo (TREPS) and short term deposits, the fund house has to follow internal valuation metrics i.e. amortization based valuation i.e. average yield of such securities divided by 360
- For other securities like derivatives, CPs, CDs and market linked debentures (MLDs), fund houses have two options – a. amortization based valuation and b. follow valuations given by rating agencies. However, the difference between traded price (amortization based valuation) and price quoted by rating agencies of a security should not exceed 0.025%
However, from May 1, 2020, while the first two clauses remain unchanged, fund houses having exposure to other securities like derivatives, CPs and CDs in their liquid funds will have to follow rates or price quoted by rating agencies.
Volatility in liquid funds will go up due to marked to market approach. However, it will not have significant impact on liquid fund returns due to modified duration, which is measure of change in valuation in response to change in interest rates. For instance, multiplier will be 1/12 or 0.083 for modified duration of one month. Similarly, for modified duration of one week, multiplier will be 1/52 or 0.019. This means, volatility will continue to depend on the severity of the market movement instead of change in valuation norms. To put in perspective, a short duration fund with a portfolio maturity of say 3 years and modified duration of say 2.75 years, will have a multiplier of 2.75.
Advisors should recommend overnight funds to investors who cannot digest volatility. Also, since liquid funds will now have 7 day exit loads, overnight funds score over liquid funds. In addition, the risk of getting negative returns in overnight funds is nil.