Credit Impact: Liquid Funds Returns Get A Fillip On Rising Systemic Liquidity

As yields tumble in the overnight and liquid paper, liquid fund returns are being prepped up considerably. CD yields have dipped almost to 6.5-6.6 percent of 2-3 month maturities, which is comparable to the current repo rate of 6.5 percent.

Liquid funds returned 0.61 percent in the past month as per data from Valueresearchonline, while ultra-short debt funds and short-term debt funds provided 0.85 and 1.28 percent returns the past month. This works out to over 7.32, 10.2 and 15.4 percent returns on an annualized basis for the above categories respectively.

Excess liquidity in the system is driving returns of liquid and short-term funds, thanks to rising inflows and open market operations of the RBI. The RBI is keeping the liquidity taps flowing because of the upcoming FCNR redemption that is slated from September.

Says R Sivakumar, head fixed income, Axis Mutual Fund: "The system has excess liquidity which is going into short-term assets. RBI has been very proactive in adding liquidity into the system. Our expectation is that the reasonable part that we have added liquidity so far is front-loading the liquidity required at the time of FCNR redemptions."

All this is driving the returns of the money market funds, which is popularly known liquid funds. As yields of CDs and T-bills have dipped, returns of liquid funds have turned sweeter.

As per Valueresearchonline data, liquid funds have fetched 1.86 percent returns in the past three months. On an annualized basis, returns work out to 22.3 percent.

But Sivakumar thinks that there could be an offset in outlook once these dollars leave the system between September to December 2016. Says Sivakumar: "RBI is likely to provide liquidity to offset the redemptions. But this period of excess liquidity will move more towards neutral and perhaps some amount of tightness once the redemptions are done."

Liquid funds are one of the largest segments of the mutual fund industry, benefiting immensely from these easy liquidity conditions. According to CRISIL, the AUM of liquid funds rose 23.3 per cent to ?3.01-lakh crore. Historical trends show that quarter-end outflows (June) in the category are reversed in the subsequent month (July) as banks and corporates re-invest surplus funds, Crisil pointed out.

Over the next few months, however, once the liquidity conditions returns to normal, liquid funds returns is likely to follow suit. Says SivaKumar: "The very short-term is really reacting to the liquidity conditions today, which shows that there is excess liquidity. Perhaps once the FCNR is done then we will be able to judge about the excess liquidity in the system, which is likely to be around December."

Till then investors in liquid funds, usually firms and high networth individuals, are likely to enjoy higher returns in the next few weeks or months.

However, if short-term yields of CDs and T-bills rise after FCNR redemptions are over, returns of liquid funds could get impacted. Liquid funds invest in papers at the shorter end of the yield curve largely in papers that mature in 1-3 months.