Debt mutual funds go conservative versus their declared risk capacity

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Six months since the potential risk class (PRC) norms issued by the Securities and Exchange Board of India (SEBI) were implemented, mutual funds appear to be using the matrix to take buffer in terms of their risk capacity rather than align to the reported PRCs.

The norms, issued by the capital market regulator in June 2021 and implemented in December, were aimed at improving risk disclosures in a bid to obviate the credit and liquidity crises that have plagued debt mutual funds in recent years.

With those crises still fresh in mind, investors remain wary of higher risk in debt funds. And though corporate balance sheets have improved since then, mutual funds continue to shy away from taking higher risk.

From the funds’ point of view, playing conservative ensures they can invest as and when an opportunity emerges.

For investors, however, it becomes imperative to look at both reported PRCs and the actual level of risk captured by the risk-o-meter of the scheme.

In a bid to create awareness among investors about the maximum risk (interest rate and credit) that a debt fund can take, the PRC circular has laid down thresholds as follows:

Debt fund portfolios reflect conservative trend

A CRISIL Research analysis of 218 debt mutual fund schemes shows their actual risk profiles are conservative compared with their reported PRCs.

The analysis considered debt mutual funds ranked in the CRISIL Mutual Fund Ranking of June 2022 and analysed the portfolio during the six month period (January 2022 – June 2022) to calculate average PRC scores for the period.

The analysis showed that only 27 percent (58 schemes) have their portfolio aligned to their reported PRCs.

While the reported PRC of most funds falls in the Class B bucket in terms of CRV, they have taken a more conservative approach in the past six months and now form part of the Class A bucket.

Similarly, in terms of duration, most funds have reported themselves in the Class III bucket, but as per the 6-month MD average, most funds are falling in Class I or II bucket.

To understand the distribution of funds better, the analysis tried to further break up the PRC matrix findings of funds based on credit risk and interest rate risk.

Note: While CRV is to be calculated on dirty price, CRISIL considered portfolios disclosed by asset management companies that are based on clean price. The analysis ignored exposure to the Bills Rediscounting Scheme, fixed deposits, interest rate swaps, infrastructure investment trusts, mutual fund units, and preference shares as the circular does not mention anything about their treatment. The numbers in each cell denote the number of schemes plotting under specific bucket.

The CRV analysis shows that 92 schemes place themselves in the Class B bucket, but form part of the Class A bucket as per the past 6-month average. Similarly, 20 schemes reported their CRV in the Class C bucket, but their 6-month average placed them in Class B. This indicates the conservative credit stance that funds are leaning towards based on the current market scenario.

That said, reporting in the most aggressive CRV bucket does lend the funds more flexibility. This trend was visible across all categories, especially in credit risk.

For instance, as per SEBI’s mandate, credit risk funds are to maintain 65 percent of their assets in AA and below securities, which is reflected in their reported PRC CRV positioning in the Class C bucket. However, as per the 6-month average CRV, most of these funds fall in the Class B bucket.

In the gilt category, the reported and calculated six-month average CRV of all funds fell in the Class A bucket, which is in line with SEBI’s mandate of investing 80 percent of assets in government securities.

Note: The analysis ignored exposure to the Bills Rediscounting Scheme, fixed deposits, interest rate swaps, infrastructure investment trusts, mutual fund units, and preference shares as the circular does not mention anything about their treatment. The numbers in each cell denote the number of schemes plotting under the specific bucket.

For the calculation of interest rate risk value (IRV), the average of the past six months’ MD (January-June 2022) was considered.

The IRV analysis shows that, while 86 schemes place themselves in the Class III bucket, they all form part of the Class II bucket as per the past 6-month average.

In the case of liquid funds, positioning in the interest rate risk bucket is the same for both reported and calculated IRVs — in line with the category’s mandate of maintaining and investing in securities with maturity of less than or equally to 91 days.

Similarly, in money market funds, reported as well as calculated IRVs are in the same bucket of Class I, in line with the category’s mandate of investing in instruments having maturity up to one year.

It is, however, important to note that the conservative IRV could also be an outcome of the volatility seen in interest rates in the first six months of 2022.

Category-wise findings

The category-wise analysis of IRV and CRV shows that categories that do not have a duration mandate, such as banking and PSU, corporate bond, dynamic bond, credit risk and gilt funds, show a huge deviation in their six-month actual IRV and reported IRV. In the case of CRV, a huge deviation was evident in categories other than gilt, money market, and ultra-short duration.

Summing up

The analysis shows clearly that debt mutual funds are conservative in their risk profile. This gives them the leeway to increase risk in the portfolio if an opportunity arises.

For investors, however, it is important to look at the reported PRCs to gauge the maximum risk within debt funds and map it to their risk-return profiles. They need to monitor the mutual fund portfolios on a regular basis to understand the risk being taken by the fund manager and whether it aligns with their risk profile.

Jiju Vidyadharan is Senior Director, CRISIL Research. Views are personal.

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