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Bond funds: Can single credit-class funds lower risk perception?

Investors’ risk perception for bond funds has increased significantly in recent times. This article suggests that diverse credit-class sectors and the broad portfolio mandate may be the reason for the perceived risk.

B. Venkatesh

The Association of Mutual Funds of India (AMFI) has stated that bond funds, especially fixed-maturity plans, are invested in high-quality securities and that there is no cause for concern regarding their credit risk.

But no amount of reassurance is likely to help when investors are nervous.

This article suggests that the diverse credit-class sectors in the bond market and the broad portfolio mandate may be the primary drivers of risk perception among the investors.

It explores the idea of offering funds that will invest in single credit-class sector and argues that such funds will lower investors’ risk perception.

Risk perception

Bond funds, which include income funds, liquid funds and gilt funds, constitute nearly 70 per cent of the total assets managed by the mutual fund industry. It is small wonder then that there is concern among investors regarding the credit-risk exposure of these funds.

Investors’ fear may be due to the fact that the portfolio manager can continually change the portfolio composition within a given mandate.

Suppose a liquid fund has a mandate to invest in “debt and money market instruments” according to its offer document. What if the fund had been investing in commercial papers (CPs) and T-bills till 2007 but has taken exposure to structured obligations this year?

An investor staying with the fund since early 2007 may find it difficult to gauge its credit risk, for structured obligations may carry higher risk than CPs.

The case with fixed-maturity plans (FMPs) is no different. These funds were earlier investing in government bonds though there was a mandate to take exposure to corporate bonds. Several funds over the last year switched to bonds issued by real estate companies for yield pick-up.

While this did not shock the investors then, the sharp decline in asset prices this year has led to an increase in risk perception now.

The structure is not entirely different from a diversified equity fund, where the portfolio manager can shift weights from large-caps to small-caps.

But investors understand equity market far better than the bond market. And that moderates the equity risk-premium but increases the perception of credit risk.

Credit-class structures

Currently, bond fund offerings are based on the tenor of the fixed-income securities. Thus, asset management firms offer money market instruments, short-term funds and long-term funds.

The problem is that a short-term fund invests in various credit-classes which make it difficult for investors to gauge credit risk when there is a change in portfolio composition.

Investors may be better served if asset management firms instead offer funds based on credit risk and tenor.

The bond market can be broadly categorised into following credit sectors: call money, CDs and t-bills; CPs; corporate bonds (1-5 years); corporate bonds (6-10 years); short-term government bonds (1-5 years); medium-term government bonds (6-10 years); and finally long-term government bonds (above 10 years).

Asset management firms can offer primary funds that each assumes exposure to only one of these seven different credit sectors and maturity buckets.

So, there will be funds that will invest only in short-term government bonds or ones that will invest only in CPs.

This makes it easy for the investors to gauge the credit risk and duration-based market risk. The seven categories of primary bond funds can be used to offer custom-tailored solutions to mass affluent and retail investors.

A diversified short-term bond fund, for instance, will use the following primary funds to structure its portfolio — CPs; call money and t-bills; short-term government bonds; and short-term corporate bonds.

The custom-tailored solutions will, hence, be a fund-of-funds offering.

An investor will know that this fund will carry exposure to all these sectors; sector weight may vary depending on the portfolio manager’s tactical asset allocation strategy.

The risk perception will be lower than that for the short-term bond funds available now. The reason is to do with investor psychology.

Risk perception is a function of bad outcomes. A bad outcome can feel good when an investors’ expectation is something worse. Expectation is a function of assets returns, which depends on the visibility of assets. Using primary funds to build multi credit-class sector funds helps in better asset visibility. And that could lead to lower risk perception.

Conclusion

Will asset management firms have enough takers for primary funds? This is important because asset size is an important driver for fund returns and is a source of revenue for asset management firms.

The demand for primary funds may be significant as they offer better investment solutions.

Those who are risk-averse and want short-term exposure can choose call-money- and -t-bills funds.

Those who are prefer current-style bond fund offerings can take exposure through multi credit-class bonds that will invest in several single credit-class bonds. Either way, demand can be created for primary funds.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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