Mutual Funds

How Sebi’s latest risk matrix promises value-add for debt MF investors

Maulik Madhu BL Research Bureau | Updated on June 12, 2021

Caps on maturity of individual securities and checks on fresh investments in perpetual bonds are positives

In the backdrop of the Franklin debt MF fiasco, regulator SEBI has unveiled the latest Potential Risk Class Matrix (PRC Matrix) for debt mutual fund schemes that is aimed at disclosing to investors the maximum level of risk that the schemes can take. As seen in the Franklin MF case, many schemes took high amounts of credit risk but were marketed as ultra-short, short, medium duration, etc., and valued certain bonds based on interest reset date rather than the date of maturity.

The latest matrix will capture two key risks that all debt funds face — interest rate risk and credit risk. It is to serve as an add-on risk indicator to the earlier introduced Risk-o-Meter. Mutual fund AMCs have been displaying a pictorial Risk-o-Meter for all their MF schemes in the monthly fact sheets since January 2021. Each scheme is labelled choosing one of six different risk levels, ranging from low to very high, on the meter.

While the Risk-o-Meter indicates the actual risk that each scheme carries as of each month-end, the new 3X3 Potential Risk Class Matrix will display the maximum extent of risk a scheme can undertake. The actual risk a scheme takes can be lower than the maximum risk it is allowed to take.

Mutual fund AMCs will have to disclose the Risk Matrix in their scheme information document (SID), key information memorandum (KIM), application forms, and annual reports. This takes effect from December 1, 2021.

Read more: Important lessons for investors from Franklin Templeton fiasco

Matrix decoded

How a debt scheme is positioned in the Risk Matrix will depend on the maximum interest rate and credit risk the scheme can take on. On the matrix, the level of credit risk goes up as you move from left to right and the level of interest rate risk goes up as you go from top to bottom. Each scheme will be ranked — low, moderate or high — on each of the two risk factors. So, a scheme that can take on relatively higher levels of both credit risk and interest rate risk will be positioned at the bottom right side (C-III) of the PRC Matrix (see table).

The maximum credit risk value (CRV) for each scheme will be determined by the weighted average of the CRV of each instrument in the scheme portfolio. At the instrument level, the CRV can range from 13 for the ultra-safe government securities, to 1 for the riskiest below-investment-grade securities. Schemes with a CRV of 12 or higher will come under class A (low credit risk) and those with a CRV of 10 or higher under class B (moderate risk). All schemes with a CRV of lower than 10 will fall under class C (high risk), a class containing schemes with a wide range of risk levels.

The interest rate risk for each scheme will be determined by its weighted average Macaulay Duration (MD). Lower the MD of a debt schme, lower is the interest rate risk. Schemes with a MD of up to 1 year will come under class I (low interest rate risk) and those with an MD of up to 3 years will fall under class II (moderate risk). Schemes under class III (high risk) can have any MD. Gilt funds and dynamic bond funds are likely to fall under class III.

To start with, AMCs will have to inform their unit holders about the classification of their schemes into one of the nine cells of the matrix. Thereafter, further changes, if any, in the scheme position in the matrix too will have to be communicated to investors via SMS and by providing a link to the website where the change has been mentioned.

What’s hot

The proposed PCR Matrix promises to provide a more comprehensive risk assessment of debt MF investments backed by a few key additional features over the existing Risk-o-Meter.

Most significantly, unlike the Risk-o-Meter which categorises schemes based only on the overall scheme Macaulay Duration (scheme average maturity, simply put), the PCR Matrix additionally specifies the maximum residual maturity for each individual security in the scheme portfolio in order to cap the overall risk. Longer the residual maturity of the debt papers in the portfolio, greater is the interest rate risk. For instance, for a scheme to be placed in Class I in the matrix (that is, Macaulay Duration of up to 1 year), the residual maturity of each security held must, at max, be 3 years. This will ensure that the scheme portfolio will comprise only of papers that vary within a narrow range of maturity to comply with the overall scheme MD.

Two, the new matrix can be useful where investors want to check the interest rate risk and credit risk separately. This can highlight to new investors the risk (high interest risk but no credit risk) in, say, gilt funds. The Risk Matrix displays both the credit risk and the interest rate risk while the Risk-o-Meter combines the different risk parameters to arrive at one composite risk label. For instance, a debt scheme with relatively low credit risk and relatively high interest rate risk will come under A-III.

Three, the relatively high-risk perpetual bonds (including AT1 bonds) have been explicitly covered under the new PCR Matrix. While debt funds have been allowed some flexibility with respect to their existing perpetual bond holdings, fresh investments in perpetual bonds can only be made by schemes in Class III (high interest rate risk category).

What’s not

The re-categorisation of mutual fund schemes announced by SEBI in 2017 defines many categories of debt schemes based on their Macaulay Duration. For instance, ultra-short duration funds and short duration funds must invest in debt and money market securities such that the Macaulay Duration of the portfolio is in the range of 3-6 months and 1-3 years, respectively. This automatically caps the maximum interest rate risk up to a certain range. This, along with the level of credit risk as captured in the existing Risk-o-Meter, can be sufficient for investors.

For many debt MF schemes, the interest rate risk (indicated by the portfolio Macaulay Duration) and the credit risk (based on the credit quality of the portfolio) is unlikely to change sharply from month to month. So, the monthly Risk-o-Meter should be more than able to provide investors a quick snapshot of the risk level of any scheme. Even in situations where there are sharp changes in the duration and the credit quality of the portfolio, these will get reflected in the monthly Risk-o-Meter. In contrast, the PCR is a less frequent disclosure and may be of more use only to new investors when they first invest in a scheme.

Takeaways

The Risk Matrix may prove to be useful in case of categories such as dynamic bond funds. According to Pankaj Pathak, Fund Manager, Fixed Income, Quantum Mutual Fund, in dynamic bond funds, the duration, and so the risk level of the scheme, can vary a lot over time. The new risk matrix can inform investors about the maximum risk that such a scheme can take so that their decision to invest is not based only on the recent risk level.

Note that both Risk-o-Meter and the Risk Matrix place all schemes beyond a certain high level of risk in the same bracket irrespective of the variation in the actual risk levels among them. Equity schemes, whether large, mid or small-cap, for instance, have been labelled ‘very high risk’ by most AMCs in their Risk-o-Meter. Nifty index funds too have been labelled ‘very high risk’. Credit risk funds, on the other hand, have mostly been labelled ‘high risk’.

Hence, be it the Risk-o-Meter or the Risk Matrix, they can serve only as a first-level indicator. Seasoned investors who want more insights may want to review the complete scheme portfolio and understand the fund strategy too.

In a nut shell

Investors to be intimated on scheme’s max risk

Interest rate and credit risk to be highlighted

Serves as first-level check only. Investors need to do their homework

Published on June 12, 2021

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