Why is understanding risk important in debt mutual funds?
Debt mutual funds behave differently from what investors expect them to. Instead of steady growth and income generation over time, debt funds can fluctuate considerably as the chart below shows for some selected debt fund categories:
To guide investors regarding the type of risk embedded in debt mutual funds, SEBI has come up with the Potential Risk Class matrix that is a part of the mandatory portfolio disclosures of debt mutual funds. Before understanding the matrix, we will look at how risk manifests in a debt mutual fund.
A quick primer: risk and return in debt funds
Like all mutual funds, and unlike Fixed Deposit (FD), debt fund returns (and the principal invested) are not guaranteed and returns can fluctuate continuously.
In a debt mutual fund, risk (and return) comes from two main sources:
Credit risk
This determines how good the underlying bond is in terms of the issuer’s capability of paying back the regular interest (called a coupon) and the money borrowed (the principal) of the bond.
Issuers are rated by Credit Rating agencies (like S&P, Moody’s, Fitch, CRISIL, Indiaratings, etc.) and given a scale like AAA (best quality), AA (lower than best), to D (worst quality - unable to pay back the money borrowed). The higher the credit rating (AAA or SOV - for the government), the lower the coupon and the lower the credit risk.
This affects the prices of bonds already in the market.
If an existing bond offering a 7% coupon is pitted against a new bond that offers a lower coupon of 6% (interest rates are falling), then the existing bond is more desirable and so is a debt fund holding these older 7% bonds. The reverse happens if interest rates rise in the economy - debt fund NAVs fall. This metric, for measuring interest rate risk, is called Modified Duration, and is available for all debt funds. It measures the rate of change of the portfolio NAV due to changes in interest rates.
For our framework for selecting debt mutual funds, we will stick to a duration of up to 1, which effectively means that for every 1% rise (fall) in interest rates, the fund NAV will fall (rise) by 1%. The debt fund categories that satisfy this criterion are overnight, liquid, ultra-short, low duration, and money market funds. This is the full list from SEBI. The new June 2021 debt fund classification by SEBI defines Macaulay Duration of less than or equal to 1 year as Class 1. This recommendation is in line with the SEBI definition since Duration < Macaulay Duration for all debt funds.
In general, funds with large AuM increase diversification. There is no role of star ratings or past performance in choosing a debt fund.
Result of credit and interest risk: liquidity risk
Debt fund investors should be wary that, unlike western countries, there is no bond market in India for corporate bonds. There is a market for government bonds, but mostly banks and other institutions participate in that market with deals happening in crores.
Credit and interest risk manifest as liquidity risk. Liquidity risk means that the bond cannot be sold without incurring a substantial loss since there would not be any buyers. The lack of buyers could be due to:
Credit rating downgrade: No one wants to buy the bond since the issuer is not paying interest or the principal.
Interest rate changes: Older bonds at lower interest rates may suddenly find a lack of interest from buyers when interest rates move up.
We will now apply these definitions of risk in understanding the SEBI matrix.
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What is the SEBI Potential Risk Class matrix?
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SEBI, as per circular SEBI/HO/IMD/IMD-II DOF3/P/CIR/2021/573 issued on June 07, 2021, amended the regulations for the classification of debt funds to better allow investors to understand the risks when choosing one. These new classifications are effective since December 2021. As per the new SEBI criteria, risk in debt funds is classified as Credit risk and Interest Rate risk. These risks are combined into a matrix called the Potential Risk Class (PRC) matrix.
Why was the SEBI Potential Risk Class matrix introduced?
One of the triggers for introducing the Potential Risk Class was the Franklin Templeton incident when six debt funds run by Franklin Templeton were frozen in April 2020 citing liquidity issues.
Where can investors see the SEBI Potential Risk Class matrix?
As per SEBI, the matrix should be available on the front page of the new fund offering (NFO) application form, Scheme Information Documents (SID) and Key Information Memorandum (KIM) as well as the common application form of the AMC.
How does SEBI classify credit risk?
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SEBI classifies the credit risk of the bonds in the debt fund portfolio based on the credit rating using a 13-point scale called Credit Risk Value (CRV). The CRV number is then used to create three bands: A,B,C. To understand credit ratings better, please refer to this article: Frequently asked questions on Credit Rating: the complete guide
How does SEBI classify interest rate risk?
SEBI classifies interest rate risk using the concept of the Macaulay Duration. This number is an indication of the number of years the investor needs to be invested in a bond to ensure that they have got back their investment. To understand duration better, please refer to this article: Should you match debt portfolio duration with goal duration?
SEBI defines 3 thresholds each for credit and interest risk for defining the matrix using the maximum weighted average values. For credit risk there are classes A (safest) to C (least safe). For interest rate risk, the classes are I (least fluctuation with interest rates) to III (highest fluctuation with interest rates). Investors should note that the matrix is a qualitative tool and good for comparing one debt fund with another. It does not provide an absolute numeric definition of the risks in the fund.
Can the position of a debt mutual fund in the matrix change over time?
Debt funds invest as per the investment mandate available in fund documents like the Scheme Information Document (SID). They are also governed by the SEBI classification on debt funds which has led to 18 categories of debt mutual funds. Unfortunately, many debt fund categories are loosely defined, like say Low Duration, which has the potential of drift in the risk dimension that is not tightly specified by SEBI. The onus is on the investor to continuously monitor the portfolio disclosure statement of their debt funds to ensure that the fund invests as per their requirement and understanding of risk.
Can the following the Potential Risk Class matrix help me get back my investment as an investor?
The Potential Risk Class matrix is a tool for comparing debt funds amongst themselves based on risk. There is no guarantee that investors in A-I rated funds will always get their money back. It is just that, relatively speaking, an A-I rated fund has lesser risk than B-II which in turn has lower risk than C-III.
What does a sample risk classification matrix look like?
The above image, from the SEBI site, shows a sample matrix with value B-II. In this, the CRV grade is Class B (AA or better-rated bonds) with the Macaulay duration of the portfolio being 3 years or less. This portfolio, therefore, has a fair bit of risk, though unquantified, and investors understand if they are comfortable vs. say an A-I rated fund or consider one with more risk in the hope of getting a higher return.
Can the Potential Risk Class matrix warn of incidents like the Franklin fund closure in advance?
The Franklin incident had several reasons that lead to the closure and the final result was precipitated by the COVID-19 pandemic’s effect on the domestic bond market. One of the reasons that the funds were impacted was having longer maturity bonds in a portfolio that should be short maturity on average. If there is a liquidity event, the longer-maturity bond will give back money a lot later than the rest of the portfolio. Given the way the Potential Risk Class matrix is defined, the maximum residual maturity of each bond in the portfolio is capped:
Class I: MD <= 1 year: residual maturity should be less than 3 years.
Class II: MD <= 3 years: residual maturity should be less than 7 years
Class III: MD any: residual maturity has no limits
However, there is no such cap in case the bonds are issued by Central/State governments in cases of Class I and II categories.
Which risk category should investors choose?
We prefer that investors avoid unnecessary risk in the debt asset allocation. We have covered this as a framework reproduced below:
Pre-requisite: Investment goal should be 3 years or further away
Category of fund: overnight, liquid, ultra-short, low duration or money market funds only with Macaulay duration <= 1 year (alternatively modified duration <= 1 year) [Class I: (Macaulay Duration <= 1 year) as per SEBI]
Credit-quality of portfolio: mix of SOV/AAA/A1+/Cash only [Class A (CRV >= 12) as per SEBI]
Maximize the expected return after factoring in YTM, TER, modified duration and the portfolio quality
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This post titled How to use the SEBI Potential Risk Class matrix to understand risk in debt mutual funds? first appeared on 16 Nov 2022 at https://arthgyaan.com
