Why do Liquid Funds fall in Value?

As the name suggests a “Liquid Fund” is a mutual fund that invests in Liquid Assets. These assets consist of instruments like Certificates of Deposits, T-Bills, Commercial Papers, Term Deposits and more. These instruments can directly be bought from the issuer or through secondary markets. 

To better understand this, we will consider all these Liquid Assets as “Bond”. Bond is very similar to these liquid assets; in fact, all these Fixed Income assets have similar characteristics.

It is very different from James

A bond is a fixed income instrument that pays a regular cash flow as agreed upon. It is basically a loan agreement between the bond issuer and bond buyer where bond issuer promise to pay a specified amount of money at specified future dates.

There are hundreds of types of bonds which have some or more variations in their characteristics. There can be a Fixed Rate Bond, there can be a floating rate bond, there can be a Zero Rate bond, and many more. BUT, one thing is common among all these bonds, as they move towards maturity, their value increases; obviously, it should not be a negative rate bond (yes, we do have negative-yielding bonds, which we may discuss in a separate article).

Now, there is a loan, that needs to be repaid! With Interest! So the value must always increase as we move towards maturity, right; then how do Liquid Funds lose money? 

To explain this, I will create a simple example, 

ASP Whiterock Liquid Fund is a fund that invests in 10000 bonds of Unreliable Industries Limited (UIL). The bond is bought at a price of INR 99 and will pay INR 100 at the time of maturity. It matures 100 days from now.

The total Assets Under Management (AUM) is Rs 9,90,000, and upon maturity, the AUM will be INR 10,00,000. ASP Whiterock splits this fund into 100 units and sells those units to investors. 

This gives us a Net Asset Value (NAV) per unit equal to INR 9900. We know that today the NAV is 9900, and upon maturity, the NAV will be INR 10000. (100 days are remaining to maturity)

“TECHNICALLY”,  the NAV must increase by INR 1 every day until maturity. I.e. INR 9901 on Day 1, 9902 on Day 2, 9903 on Day 3 and so on, Thus we will reach a NAV of INR 10,000 on 100th Day. Well, this is the case that happens “generally.”

So, how does a Liquid Fund fall in value?

The most common reason for the fall in the value is that Unreliable Industries Limited (UIL) defaults on the payment. Suppose, it pays only INR 80 per bond on the date of maturity. Now, our NAV which was supposed to be INR 10,000 on maturity falls to INR 8,000. Thus, “Defaults” by corporations are the most common reason for fall in NAV. (There’s a lot more to it…)

“BUT HEY, Unreliable never defaulted and I am sure that default will not be a problem, why did my Liquid Portfolio still go down?

Unreliable Industries also issued their bonds to other Mutual Funds, let’s say Khhotak Liquid Fund. Now, its March time and to show Cash on their books, Khhotak’s Big Corporate client redeemed his units on the 10th day (he would again put it back). As Khhotak Liquid Fund sold the bonds, the price of the bond went down (remember primary Demand and Supply mechanism?)

Now, ASP Whiterock’s client, when he saw his NAV going down, spooked! He also places a redemption request to ASP. ASP had to sell his client’s unit to pay him. These types of bonds are illiquid, and the sale further reduced the value.  On the 10th day, when the investor was expecting his NAV to be INR 9910, he actually realized INR 9890.

Obviously, if he would have waited for 90 more days, he would realize his full 10,000. But, panic doesn’t even spare the good ones. This investor’s action converted his notional loss into an actual loss.

BUT, Again, this does not mean that the Panic is unconventional. Sometimes the panic is very real and logical. Well, that’s a different topic altogether.

In Indian Markets, we saw such moves recently between 16th-31st March. Again, reasons being “March Adjustment”, COVID-19 panic, FII’s sell-off, etc. 

The most major fall in Indian Liquid Fund markets was in 2018 during the IL&FS episode.