In a circular issued today, the Securities and Exchange Board of India (Sebi) came out with a risk classification matrix for debt mutual funds which takes both credit and interest rate risk into account. The matrix addresses a long standing gap in regulations which allowed fund houses to hold high credit risk paper in debt schemes defined only by duration, as had happened in some of the Franklin Templeton schemes frozen on 23rd April 2020. Credit risk is the risk of defaults and downgrades due to the inability of a bond issuer to repay the debt fund. Interest rate risk is the risk of bond prices falling due to interest rate hikes. The risk matrix will consist of 9 cells graded along these two parameters. The risk classification will go from AI (lowest risk for credit and interest rates) to CIII (highest risk for credit and interest rates). Mutual Fund houses will have to implement the new matrix by 1st December 2021.
According to Sebi, the interest rate risk will be classified into 3 buckets. The lowest risk bucket called Class I, can have a Macaulay Duration (MD) up to a maximum of 1 year, the moderate risk bucket (Class II) can have MD up to 3 years and the third (Class III) can have MD above 3 years. The regulator also laid down that Class I schemes can have debt paper with a maximum residual maturity of 3 years and Class II schemes with a maximum residual maturity of 7 years. No maximum residual maturity has been laid down for Class III. The norm is likely to enable investors to identify schemes in short duration buckets holding high residual maturity paper, as had happened in some of the Franklin Templeton mutual fund schemes.
Credit risk will be classified into 3 buckets in the matrix. Credit risk value (CRV) greater than 12, CRV greater than 10 and CRV less than 10. CRV is the weighted credit risk value of each instrument according to credit rating. Mutual Funds have to display the risk cell on their Scheme Information Documents (SIDs) and other major documents.
Once a scheme is placed in a particular cell, a change in cell would constitute a change in fundamental attributes which would involve giving existing investors the chance to exit without paying exit load. The regulator however made certain allowances for mutual funds holding perpetual bonds of banks in the risk classification exercise.
“Sebi has been taking several incremental steps to improve the labelling and risk framework for debt mutual funds and this is the latest such step. Investors will be able to better understand the product they are investing in, with this matrix,” said Mahendra Kumar Jajoo, Chief Investment Officer (CIO), Mirae Asset Investment Managers (India) Pvt Ltd.
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