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Posted by: Amit Trivedi and Uma Shashikant on Fri, Jul 19th, 2013

Carnage in Liquid Funds Explained

Carnage in Liquid Funds - Explained


Liquid fund NAVs do not drop, since their primary source of return is accrued interest. What happened on July 16th?

 

RBI decided to make the depreciating rupee scarce, with the objective of making speculation costly. RBI surprised the markets by increasing the bank rate by 2%-from 8.25% to 10.25% after market hours on 15th July, 2013. The NAV for liquid funds as a category dropped across the board, due to this sharp increase in overnight rates. 

 

If a liquid fund earns around 7% p.a that translates into 0.019% every day (7% divided by 365).  If there were no expenses or mark to market losses, the appreciation in daily NAV would be equal to this accrual of interest. If there was no default, why did this NAV drop? An increase in interest rates means existing bonds will lose value on a mark-to-market basis.

 

To estimate the mark-to-market loss from this unexpected rise in interest rates, we can use the fund’s duration. For every 1% rise in interest rate, the NAV of the fund would drop to the extent of the modified duration. If the modified duration of the fund was 0.1, a 1% rise in interest rate, means the NAV would drop by 0.1% (0.1 times 1).

 

Consider this example:

 

ICICI Prudential Liquid fund

 

ICICI Prudential Liquid fund

 

Data taken from factsheet dated 30 June, 2013.

*RBI changed bank rate from 8.25% to 10.25%, hence impact assumed to be 2%.

#Data taken from FE Analytics

 

The daily returns are usually made up of two components - accrual less expenses. If there was no market risk, the returns from this fund should be 7.74% (8.24% - 0.50%). Since the NAV is calculated on a daily basis, the interest is accrued to the NAV every day. This would be 7.74% / 365 = 0.0212%.

 

The mark-to-market hit happened since the RBI changed the interest rates by 2%. Given that the modified duration of the scheme was 0.096, the impact on the NAV should be negative 0.192% (2% X 0.096)

 

Thus, the net return from the fund for that one day should have been 0.02121% - 0.0192% = - 0.1705%. The actual drop in the NAV was -0.17%. 

 

It is easy to see that the impact of the same decision on various liquid funds would have been a function of the following:

  1. Yield of the fund (funds with higher yields would have been better cushioned than those with lower yields)
  2. Expense ratio of the fund (investors in funds with lower expense ratio would have been better off than those with higher expense ratio)
  3. MTM risk as measured by modified duration (funds with higher modified duration would have lost more than those with lower modified duration.

 

Liquid funds have a very small duration, or low mark-to-market risk. But the change in interest rates (2%) was too high, leaving them with a high impact.  Across the category the NAV dropped by 50p to 12p in a single day.

 

What are the implications?

  1. Corporate treasuries and banks that would have typically put in redemptions, assuming that NAV would be on accrual basis, would have actually lost. They would have expected a higher NAV, but got a lower NAV since funds had adjusted the NAV downwards for a mark-to-market loss.  This would have helped prevent a repeat of 2008.
  2. Investors who came in before the event for a short term, would have lost, since the interest income they earned was about 0.02p a day, while they suffered a loss of 17-23p in a single day.  This was due to a completely unforeseen event, and therefore not a cause for panic.
  3. Investors in the fund, who do not need the money immediately, might be better off staying put. A loss of 20p can be recovered by a fund earning 2p a day, in a matter of 10 days. 
  4. Investors who came in after the crisis, would have got a good price, since the NAV was depressed by a MTM loss, with no actual damage or default on the portfolio. If there is a low probability of another such harsh event, they may be marginally better off.

 

Amit Trivedi runs Karmayog Knowledge Academy. The views expressed are personal. The scheme names used are only for the purpose of illustration and not recommendations. The author can be reached at amit@karmayog-knowledge.com.

Harshil Roy on Tue, Aug 6th, 2013 4:48:20 pm

Hello! As mentioned in the blog and known to the word that normally liquid funds are value on accrual basis. They turn on Mark to Market suddenly on one day, the question is why? We have seen interest rate volatilities many times since 2007-08, but have not seen this kind of an event before. What are the criterias for which they have to turn to M2M? Theoretically we know that valuation losses need to be shown for NAV computation. Is that the reason? Thanks in advance.

Vikas Kumar on Sat, Jul 27th, 2013 10:19:49 am

Nice Liquid Fund analysis

MAHEK SHAH on Mon, Jul 22nd, 2013 8:03:10 pm

Excellent Information. This will help us to explain better to our investor. Thanks for sharing your insight.

Sonesh Dedhia on Sun, Jul 21st, 2013 5:34:17 pm

Thanks for the insights. Simple and easy to understand. Good Job :)

Nikhil Thakker on Sat, Jul 20th, 2013 10:22:41 pm

Thanks Mam for such an nice description. This will help us for explaining in better way to our investors. Thanks

SIVASANKARAN on Sat, Jul 20th, 2013 3:56:43 pm

WELL DONE. THANKS A LOT FOR A LOT OF INFORMATION

Amit on Sat, Jul 20th, 2013 3:10:36 pm

Thank you. you made it so simple that even a layman can also understand completely.

Ramkumar on Sat, Jul 20th, 2013 12:44:06 pm

Very usefull communication

SURI SEETA RAM on Fri, Jul 19th, 2013 10:09:14 pm

Tough job made easy. Thanks. However on second thoughts, I feel, "It's easier to evaluate the Devastation but Impossible to Predict it and Keep Safe". The Pandits, Press and Regulators try evaluating Distributors based on this Impossible Skill. Ironically, some promise to even impart it....

Ajit Purohit on Fri, Jul 19th, 2013 7:47:41 pm

We expect that Liquid Funds will not turn negative, but it is not so, the explanation given proved it.

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