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What debt fund investors must know about SEBI’s new risk class matrix

Fund houses now have to communicate the maximum risk they intend to take

June 14, 2021 / 09:50 AM IST

SEBI’s earlier mutual fund categorization norms of October 2017, which were implemented in the first half of 2018, helped in giving a structure to the various scheme categories. Till that time, it was about how the fund categories evolved historically, on demand from investors and  how AMCs responded. Subsequent to the SEBI guidelines, the contours were laid down on what a fund in a category is supposed to do and what is beyond the scope. However, in spite of the ground rules laid down, there were lacunae, in the areas left blank. In this backdrop, the Circular on Potential Risk Class Matrix issued on June 7, 2021 helps a lot in clearing the ambiguities.

Before we discuss the content of the latest Circular and how it helps, let us briefly look at some of the lacunae, for perspective:

-Category definition does not include credit rating: In only two debt fund categories, namely corporate bond and credit risk, the credit rating is mentioned as a criterion. Hence, in other categories, the credit quality is left to the AMC’s discretion;

-Category definition does not include security-wise maturity: Except for liquid and money market funds, it is the portfolio maturity that is mentioned. This is the weighted average of all the instruments in the portfolio. The implication is, some instruments can be of significantly longer maturity.

A circular that addresses shortcomings


Now let’s come to the Circular. While the earlier Circular of October 6, 2017 remains as it is, AMCs now have to communicate the maximum risk they intend to take. In other words, while the flexibility given in the earlier circular remains in place, the AMC has to internally formulate and communicate its intentions. This will add to the clarity of investors as to what they are getting into. What does the latest Circular state? Debt funds will be classified in terms of potential risk class (PRC), measured by two parameters – interest rate risk as per Macaulay Duration of the portfolio and credit risk as per credit rating of instruments in the portfolio.

For interest rate risk, there are three defined classes: Class I where the Macaulay Duration (MD) is less than one year; Class II where the MD is less than three years; and Class III where the MD can be anything, as there is no upper limit. From the investor’s perspective, Class I interest rate risk means the AMC will keep the portfolio duration less than one year at all times, at least till the next notice in case it is changed. Class III interest rate risk means the investor is entering into potentially higher volatility. Lower the risk class, lower is the volatility. For credit risk, the parameter is credit risk value (CRV). The scale defines a score of more than 12 as Class A with no upper limit, more than 10 (with 12 as the implied limit) is called Class B and less than 10 is referred to as Class C. For measuring the CRV, the scale has been defined with Government Securities or cash equivalent given a score of 13, AAA as 12 and so on. Lower the credit rating, the lower the number. Hence Class A is the best as the AMC is committing that the fund will comprise G-Secs and AAA. Class C, which has a CRV of less than 10, will have a portfolio that will comprise securities with credit rating AA and below.

Laying down the maturity limits

What is new and important in the recent Circular is that it lays down the maximum maturity of individual securities. For funds with interest rate risk / volatility risk Class I, which is portfolio duration of less than one year, the maximum residual maturity is three years. For a fund in Class II, i.e., duration less than three years, the maximum maturity is seven years. This does not include Government Securities.

The implications are: (a) while it retains the flexibility of the earlier Circular to an extent, it lays down the limit of maturity of individual securities, which imparts discipline; and (b) fund managers cannot do “barbell” to a significant extent. Barbell is a strategy where part of the fund is invested in long maturity securities and a part in short maturity, so that the two average out. The Barbell strategy can be potentially volatile, hence limits are required.

There is time to go for the implementation of this Circular, which is December 1, 2021. The extent to which the efforts will be fruitful depends on the extent to which investors refer to it. The risk-o-meter has been revamped from January 2021, but only a few investors refer to it to understand the risk level. Investors will do well to take the services of an advisor / distributor to make informed decisions.
Joydeep Sen is a corporate trainer (debt markets) and author
first published: Jun 14, 2021 09:50 am

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