Are Debt Funds SAFER with new “10% in Liquid Assets” rule?

In a recent circular (link or download here), SEBI has asked debt funds to invest at least 10% in liquid assets like cash & cash equivalent, government securities, repo on government securities and T-bills.

The rule is applicable to all debt fund categories except the overnight funds, liquid funds, gilt funds and gilt fund with 10-year constant duration funds.

The reason for excluding few categories in my view is because i) the liquid funds already hold minimum 20% of their corpus in liquid (since April 2020); ii) overnight funds are already very liquid as they only invest in papers maturing in 1 day; and iii) both categories of gilt funds invest 80% or more in safe government securities

After the debt fund turmoil (read this) earlier in 2020, SEBI is gradually tightening the operational norms for debt funds to make them safer. I also wrote about this aspect that may be, time had come for a review and categorization 2.0 for debt funds.

The latest announcement comes with the aim of managing risk and enhancing the liquidity framework of debt funds. If you remember, there had been fears regarding liquidity of debt funds and it was because of this that the debt fund turmoil had begun in first place.

And can you guess what will the debt funds do in case the exposure to liquid assets falls below the 10% threshold? As per SEBI, the fund managers will have to ensure compliance before making any further investment elsewhere.


Does this ‘10% in Liquid asset’ rule make debt funds safer?

From the liquidity perspective, it definitely does. Earlier, holding liquid assets in scheme portfolio was at the discretion of fund managers. But now having a rule to have at least 10% buffer in-built into the debt fund structure will enhance scheme’s liquidity and address the liquidity risk to a major extent. We already know what happened when funds didn’t have sufficient liquidity. So this 10% in liquid assets will act as the emergency buffer (sort of emergency funds) for mutual fund schemes and help in risk management.

It must be noted that this kind of buffer will only be called into action in case of extreme events. But since debt funds are perceived as safe instruments and FD alternatives, giving priority to safety (and managing liquidity risks accordingly) is of paramount importance.

The new 10% rule and related to liquid assets will be effective from 1st February 2021.

The circular has also required all debt mutual fund categories (except overnight funds) to begin stress testing their portfolios. The rules for stress testing will be recommended by a committee and will become effective from 1st December 2020. As of now, only liquid funds and money market funds conduct stress testing.

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