The liquid funds industry in India is well established and can be used as an ‘access point’ to other asset classes. Liquid funds can help corporate treasurers optimise their returns on cash, but there are regulatory and tax considerations to take into account.
Gordon Rodrigues is an Investment Director in the Asian fixed income team and is also the Head of Liquidity Asia. Rodrigues has been working in the industry since 1992. He joined HSBC Global Markets, India in 1994 as a treasury sales specialist covering corporate and institutional clients. He traded credit products on the fixed income trading desk from 1998-2002. He moved to HSBC Asset Management India in 2002 to set up the fixed income investment team and headed the team until 2007 before relocating to Hong Kong. Prior to joining HSBC, Rodrigues worked as a foreign exchange and fixed income dealer at Merwanjee Securities in Mumbai. He holds a Bachelor’s degree in Electronics Engineering and a Master’s degree in Finance, both from the University of Mumbai, India.
From the outset it should be known that the liquid funds industry in India is well-established. New asset managers launching in the country will typically offer a liquid fund as their ‘access point’ to other asset classes. India’s success in this sector can in part be attributed to the fact that it is well-regulated, with the Securities Exchange Board of India (SEBI) continuously monitoring and responding to activities in the segment. The market size as of January 2014 is approximately $40 billion, around 35% of the total mutual fund market size. Over the last five years the liquid funds segment has grown at an annual rate of 15% (source: The Association of Mutual Funds of India, AMFI). The market is 90% composed of institutional investors, eg large and medium corporates, multinational corporations (MNCs), financial institutions and banks, for which it clearly remains an attractive proposition. Whilst the economic growth rate of India has slowed in the last 24 months, it is a broad-based economy and with more investors continuing to enter the liquid funds market at the corporate and institutional level, the sector looks relatively healthy.
Liquid funds in India provide daily liquidity whereas the bank deposit structure imposes a seven-day minimum placement; there is no concept of overnight deposits in India. In addition, yields from liquid funds are typically higher than seven-day deposits. However, investors should note that the risks associated with liquid funds may be different from bank deposits. “You have access to professional credit management, transparency and efficiency and you have a higher yield and daily liquidity; these are interesting parameters in themselves,” notes Gordon Rodrigues, Investment Director, Fixed Income and Head of Liquidity, Asia, HSBC Global Asset Management (Hong Kong). But liquid funds also offer a diversified portfolio of instruments and (perhaps as importantly for corporate investors) it is “very easy to access the markets”, with bank and non-bank online trading portals and cash sweeping facilities in conjunction with mutual funds readily available.
For investments in liquid fund, short-term capital gains tax (currently 30%, assuming the investor falls into the highest tax bracket) is applicable on investments held for less than a year in the accumulating or growth option. It would be the same as that applicable to a bank deposit. If the dividend payout option is chosen, dividend distribution tax at 25/30%1 (plus surcharge and cess) is paid by the liquid fund before distributing dividend to the investors. If investments are held for more than a year, it attracts long-term capital gains tax. Long-term capital gains tax is currently applied at a rate of 10% without indexation or 20% with indexation (eg cost of the investment is indexed to the Indian government’s annual Inflation Index). Investing in a product that spans three financial years (eg starting 25th March 2014 and ending 5th April 2015) gives investors a ‘double-indexation’ benefit.
It is a benefit too that all liquid funds necessarily have the highest rating from the domestic Indian operations of global ratings agencies, Moodys (ICRA) and S&P (CRISIL). CRISIL’s high-point is AAAmfs to ICRA’s A1+mfs; there is no appetite for lower-rated funds. In order to distinguish between funds providers such as CRISIL publish fund rankings in which individual funds are placed in order of merit using a weighted system based on two key parameters: a quantitative assessment linked to returns, and a qualitative assessment of asset quality, liquidity and investment concentrations. These are dynamically ranked CPR 1-5 (1 being the highest) and are reviewed quarterly. This provides corporate treasurers with another independent source for reviewing fund quality and returns.
The Indian liquid fund environment has been based on variable net asset valuation (VNAV) from the start. Funds have to mark-to-market (or fair value) assets beyond a certain tenor with amortised cost for assets below that tenor unless a traded price is available which creates volatility as the price alters. The maturity cut-off beyond which assets are marked-to-market has progressively been reduced from six months to 91 days to 60 days currently. The alternative (used by most Money Market Funds (MMFs) in the US and UK, for example) is constant net asset value (CNAV) which uses amortised cost accounting to value all assets. In Q4 2008 India saw interest rates on a sharp upwards trend with the banking system in a “deficit liquidity scenario”. This, combined with the global financial crisis, led to concerns on liquid funds credit and liquidity risk which saw a group of international and local institutional investors pull out of the market. Although far from causing a run on funds, institutional investor concerns did trigger redemptions.
“In an illiquid market it forced some asset managers to step in and support their own funds so as not to show negative returns in a VNAV environment,” recalls Rodrigues. This hit the year’s profitability for those funds. The regulator started to pay close attention to the kind of risks being run in the liquid funds versus the level of liquidity they could provide. Until this point, investors in Indian liquid funds could buy instruments of up to one year’s tenor.
Following regulatory intervention in 2009, the longest maturity that could be purchased for an Indian liquid fund was shortened from one year to 91 days, one of the few jurisdictions in the world to take such a precautionary action. In 2012 the regulator started requiring all instruments of over 60 days maturity to be marked-to-market, every single day whether traded or not; previously they could be accounted for on an amortised cost basis.
A daily security level valuation alongside a credit pricing matrix is provided by both CRISIL and ICRA to value all 60+ days credit papers, but when this ruling came into being, the extra volatility generated in portfolios saw asset managers automatically dropping their weighted average maturities closer to 50 days. “In the global context, if an investor wants less volatility in a VNAV environment where it has fairly volatile short rates – and short rates in the Indian and emerging market context can be more volatile than in a European or US context – this essentially means that they might have to run significantly lower-maturity instruments,” says Rodrigues.
In spite of all of the Indian regulator’s actions, in July 2013 the Reserve Bank of India (RBI) recalibrated its Marginal Standing Facility (the rate at which a bank can borrow on a clean basis) to be 300 basis points above the policy repo rate. This action was seen as an interest rate-led defence against depreciation of the Indian rupee (INR). In the belief that the US would start tapering its quantitative easing programme, pressure had been put on emerging market currencies as they were sold by investors returning to USD (despite the relatively promising economic fundamentals of countries such as India). The INR came under pressure as one of a number of EM currencies facing current account deficits; the RBI’s decisive action was taken to restore stability to the foreign exchange market.
With a 300-basis point hike, even an investor with 60 days or less of weighted average maturity in its cash fund was going to see a negative NAV, explains Rodrigues. Mutual fund providers under the aegis of the Association of Mutual Funds of India (AMFI) agreed that the effect of US monetary policy could not have been anticipated and it was decided that the mutual fund management industry could pass on to investors the negative returns it had been seeing – the first time this has ever happened. It is a classic example of interest-rate risk but this time investors did not panic and those that remained invested for a week or more recovered to a position of net positive return. “This time they understood what was happening,” he says. “There was a lot more mature communication from asset managers to their clients in explaining the reality of the product.”
Corporate treasurers and institutional investors were forced to consider their reaction in context of their individual investment policies and how they should view their portfolio going forward. Rodrigues believes the industry has in fact “come out stronger from this entire experience”, knowing that it can quickly rebalance itself even in the wake of significant macro-economic events.
For corporate treasurers, the biggest advantage in terms of optimising returns on cash will be attainable if they have the ability to tranche that cash, explains Rodrigues. Under this model, normally cash is split three ways; “working capital” (on-demand cash), “core cash” (held in the medium term for a specific reason such as a dividend payment) and “strategic cash” (the long-term ‘war chest’).
Medium-term core cash options in India include fixed maturity plans (FMP). “These are closed-end products run by asset managers invested in a combination of debt securities and money market instruments,” explains Rodrigues. The securities cannot be greater in maturity than the stated tenor of the FMP, another 2009 ruling intent on avoiding interest rate mismatch between assets and liabilities and ensuring all obligations can be met. FMPs are “an established and robust market” with usual maturities being three months, six months, one year, two years and three years, the bulk being six months and one year. “Specifically in the one-year segment investors get very good tax-adjusted returns,” he notes. Investments of this type also help to maintain a diversified portfolio and, as a ‘hold-to-maturity’ product, can insulate against interest rate risk. As passively managed products the pricing attracts lower fees too, adds Rodrigues.
In terms of longer-term strategic cash the Indian market offers a segment known as ultra-short bond funds. These are often split two ways, with a weighted average maturity of two and five months for the conservative option or as a “more aggressive” version running between five and 12 months. The yield differential between these two could be as much as 50 basis points.
The RBI’s focus on containing inflationary expectations is expected to continue. The RBI repurchase (repo) rate – the rate at which banks borrow in the overnight market from the RBI – is now hovering around an anti-inflationary 8%. “In the short term we expect that rate to remain relatively stable if still on the high side” says Rodrigues. Although the central bank is looking to be more “pro-growth”, he feels that during 2014, short-term funding rates are likely to range somewhere between the repo and Marginal Standing Facility rate. From an asset manager and treasurer’s point of view “it therefore makes sense to run shorter-weighted average maturities”.
This depends on the status of the investor – 25% for individuals and 30% for corporates. The information provided is based on provisions of the Finance Act 2014. You are advised to consult your tax advisor for detailed tax implication. ↩