In this article, we will explain the categorization of debt funds in brief and its features & impact.
In Part I, we recounted that market regulator Sebi has demarcated a total of 36 categories under five broad groups to enable investors to select mutual funds with greater ease. We covered the salient features and impact of major equity and hybrid categories. Today, we will explain the categorisation of debt funds in brief and its features and impact.
Debt funds follow two strategies: duration and accrual. Duration funds benefit from interest rate movements, whereas accrual funds earn regular income from corporate bonds.
Earlier, the maturity of funds was not defined. This made it difficult for investors to track the fund’s performance. But now, transparency has improved as the fund’s portfolio duration should be aligned within the limit specified for each category.
Impact of Sebi’s mutual fund categorisation and rationalisation:
- Changes in the portfolio of existing schemes will be required. This will result in a short-term churn
- There will be greater clarity on the different levels of risk associated with each scheme
- Uniform scheme characteristics will help investors match return expectations and risk-taking ability with the type of fund to invest inShort-term performance might be impacted
- As the funds have to reshuffle their portfolios, it will lead to higher turnover
- Higher portfolio turnover may directly impact fund returns in the short- termReduction in mis-selling
- A lot of investors are misled into buying schemes which are not as per their requirement
- Sebi’s circular comes as a boon to investors who receive advice that is not suitable for them, based on vested interests of the advising financial entities
- Categorisation will help even layman investors in identifying and understanding schemesRise in fund AUM
- The merger of schemes will lead to a rise in the AUM of the target scheme, as assets of one scheme will be combined with the target scheme
- Now, the fund managers’ skills and expertise will be put to the test when they have to manage the sudden rise in scheme’s assetsBelow are the features of major debt fund categories as proposed by the Sebi circular:
Credit risk is the risk that a borrower may default in payment of interest and/or capital. Instruments with lowest credit rating will have the highest credit risk and certainly offer higher yields. In contrast, instruments with higher credit rating will have lower credit risk and hence offer lower yields.
Interest rate risk is the risk that an investment's value will change due to a change in the level of interest rates. When interest rates increase, prices on previously issued fixed-income securities decline, since investors are now inclined to buy new securities that offer higher rates. Thus, interest rates and prices of securities are inversely related.To conclude:
Categorization of schemes may lead to short-term turbulence due to changes that need to be made in each scheme. But, in the long run, this move will have a positive growth effect for the industry as a whole. With more and more investors preferring investment in mutual funds, this initiative is a step in the right direction.The writer is director at Ventura Securities.