The Short-End Worries: Liquidity May Improve

In the last few weeks, we have witnessed unprecedented volatility across asset classes, resulting from the sharp sell-off amidst flight to safety, generated by the fears around the economic impact of the pandemic. Under normal circumstances, the risk-off sentiment leads to money flowing into avenues traditionally considered as safe haven, such as debt. But in the current environment, the anticipated, far-reaching, impact on growth variables and balance sheets made cash the king.

While long term investors have the holding capacity, the investors entering the capital markets to park their surpluses with a relatively shorter horizon face the very real risk of capital erosion over their holding periods. Over the years the two preferred investment avenues utilised by investors, corporates and individuals alike, have been Arbitrage Funds and Liquid Funds. In the next two paragraphs, we will try and analyse briefly, the impact and the way forward for these two categories of funds.


Arbitrage Funds do not take directional calls in equity markets, they endeavour to lock-in the spreads between the cash-futures segments, to deliver predictable returns month on month. While volatility supports arbitrage trades as it leads to better spreads, a sell-off in a very short span of time can lead to spreads narrowing or even futures moving into discount. The FII-led heavy selling (close to Rs.60K Crs March till date) negatively impacted the spreads during the month of March, thereby dampening the outlook for April month returns. As the pace of FII selling abated, the spreads have normalised, and the funds are witnessing rollovers. The spreads which had contracted to approx. 20 to 18 bps have reverted to around 50 bps levels.

For the existing as well as prospective investors, Arbitrage Funds remain an attractive investment option for a short-term horizon of six months to one year. Given the heightened volatility and the probability of the recent phenomenon repeating itself always lurking at the sidelines, it would be recommended to make investments with minimum 6 months plus horizon.


Liquid Funds have been one of the safe avenues for short term parking of surpluses for an extended period of time, at least in terms of stability of returns. With the objective of NAVs reflecting the true picture of the value of underlying holdings, the valuation parameter was changed from accrual based to mark-to-market, and this has resulted in volatility in liquid fund returns. This was very much expected, and that is the reason for the rising popularity of overnight funds.

In the current scenario, as the FIIs exited emerging markets (including India) in a hurry, coupled with selling from domestic investors as well owing to seasonal liquidity requirements, yields moved up sharply across the yield curve. The yields at the very short end of the curve (1/3-month CD/CP) moved up by 250 to 350 bps. There are many entities, including banks and corporates, who redeem their mutual fund investments towards financial year end and put their money back in funds as the new financial year starts. The advance tax payment outflows also usually put some pressure on liquidity. When mutual funds redeem their portfolio holdings to service the redemption pressures the yields naturally rise.

But this is a passing phase. As selling pressures wane, and as the RBI and the Government introduce several measures to support the economy, the concerns of the debt market too may wither away. Some of the key measures expected at the current juncture are, policy rate cut, extension of repo or other liquidity lines to other market participants etc. Investors who are already invested in liquid funds and experiencing some mark-to-market pain, would be recommended to marginally extend their holding horizons so as to benefit from the reversal in yields. New investors may invest with a horizon of minimum one month, to ride over the volatility and to benefit from reversal in yields.


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