Over the last few months, the rules for marking to market the securities held by debt mutual funds have been modified. Before we discuss market regulator SEBI’s new rules, let’s put them in context. The NAVs (net asset values) of mutual funds are declared every working day. The value or price taken for the purpose of NAV computation is the market value of the securities in the portfolio of the scheme, i.e., the traded price at the Exchange. So far so good; the NAV of the day represents the market-traded value or price of the securities on that day. In other words, hypothetically, if the AMC (asset management company) were to liquidate the entire scheme, this is the approximate value that can be realized, subject to some impact cost.
But if the secondary market is illiquid and the last traded day for a particular security was quite a while earlier, then what is the valuation? If the last traded day’s price is taken, which is old data, it does not represent the market price or saleable price of that day. There is another way for valuing debt instruments called ‘accrual’ or ‘amortisation,’ which takes into account the purchase price plus the accrued interest till that date. However, this value too does not represent market reality; if the AMC were to sell, the realisable value may be higher or lower than the accrual valuation. Hence, the way out is an estimate of the market value of that day, in accordance with the movement in the prices of liquid securities such as Government Bonds, movement of securities of similar description, any change in the credit spread (i.e. G-Sec yield plus mark-up) of that security, etc. But, who will do it? It has been assigned to neutral organizations – not the AMC itself, but rating agencies CRISIL and ICRA. These agencies declare the daily valuation yield of all debt securities. The valuation price is derived from the yield, as per the formula used in the market.
Coming to the SEBI rules, till a little while earlier, it was required that AMCs follow the valuation given by the agencies for debt securities of residual or remaining maturity of more than two months. It meant that debt securities with more than two months remaining maturity would more or less follow the market movement, as the valuation is as per the estimate given by the designated agencies. For securities with less than two month remaining maturity, valuation was on accrual/amortisation basis. It meant that schemes holding these securities, for e.g. Liquid Funds, would deliver stable returns as the movement in the underlying market is being ignored. It works fine in a blue sky scenario. If the fund faces significant redemption pressure, if securities have to be sold in the market and if the market is tanking, there would be a problem. In such cases, the hitherto unrecognized fall in prices, i.e., prices not considered for daily NAV valuation become a reality and the fund is jolted.
In the Circular dated March 22, 2019, applicable from June 22, 2019, SEBI said that “The residual maturity for amortization based valuation as referred to in SEBI circular dated February 28, 2012 shall be reduced from existing 60 days to 30 days.” This means for more than 30-day residual maturity, NAV valuations will more or less reflect market movements. In the maturity bracket of 30 to 60 days, market realities were earlier being ignored. In the Circular dated September 24, 2019, SEBI said that “with effect from April 01, 2020, amortization based valuation shall be dispensed with and irrespective of residual maturity, all money market and debt securities shall be valued in terms of the Circular.” That is, from the start of the next financial year, the entire valuation of debt/money-market securities will be based on mark-to-market movements and not on amortisation.
Another change that has been brought about is valuation of instruments rated below investment grade, i.e., junk papers. The Circular dated March 22, applicable from June, stated that “All money market and debt securities which are rated below investment grade shall be valued at the price provided by valuation agencies.” Earlier, CRISIL and ICRA used to assign valuations for securities of investment grade alone; valuation of junk papers was left to the discretion of the AMC. Now, the valuation of junks also is provided by the designated agencies.
What does all this mean for you? In a market where there is a challenge of price discovery due to lack of liquidity in the secondary market, the best estimate given by neutral agencies is a proxy for market movements, and to that extent the NAV reflects the realisable value of the portfolio. As and when the agency assigned valuation covers the entire gamut, there may be marginally higher volatility in returns, but that is more realistic and beneficial in the long run.