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New risk matrix to classify Debt Mutual Funds

11 Mar 2022 0 COMMENT

There are two basic types of mutual funds – equity mutual funds and debt mutual funds. Equity mutual funds are suitable for investors with a high-risk appetite looking to invest for the long term. On the other hand, debt mutual funds are more suited for risk-averse investors who want capital preservation than potentially high returns.

However, that doesn’t mean debt funds are entirely risk-free. They mainly invest in interest-generating securities, such as Government and corporate bonds, debentures, treasury bills, and other money market instruments.

Any changes in the interest rates of these instruments impact the performance of debt funds. These funds' Net Asset Values (NAVs) usually go up when the interest rates fall and vice-versa. That is why it’s necessary to evaluate the risks associated with a debt fund before deciding to invest in it. There are many ways to classify debt mutual funds as per their risk-return potential.

New risk matrix by SEBI

The Securities and Exchange Board of India (SEBI) introduced a new risk matrix to classify debt mutual funds in June 2021. This new risk classification matrix is aimed to help investors better understand the funds they are looking to park their money.

This matrix considers both credit and interest rate risks. It addresses a long-standing gap that allows fund houses to hold high credit-risk instruments in debt funds defined only by duration. Below are the salient features of this new risk matrix:

  • The new risk matrix for the classification of debt mutual funds – known as the Potential Risk Class (PRC) matrix – came into effect on 1st December 2021.
  • It is a 3 x 3 matrix that considers both interest rate risk and credit risk.
  • Interest rate risks are measured using the Macaulay Duration method and funds are classified into three classes. Class I represents funds with the lowest interest rate risks, Class II with moderate risks, and Class III with the highest risks.
  • Credit risks are measured using the credit rating of each fund. All funds are again classified into three classes as per their credit ratings. Class A indicates funds with the lowest credit risks, Class B with moderate risks, and Class C with the highest risks.
 

Credit risk Class

Risk parameter

Class A

Credit Risk Value (CRV) > or equal to 12

Class B

CRV > or equal to 10

Class C

CRV

 

Credit Risk Value (CRV) is the highest for most credit-worthy instruments like G-Sec and least for instruments with poor credit ratings. Following is the CRV of the various debt instruments.

Instrument

Credit Risk Value (CRV)

G-Sec/SDL/Repo/TREPS/Cash

13

AAA

12

AA+

11

AA

10

AA-

9

A+

8

A

7

A-

6

BBB+

5

BBB

4

BBB-

3

Unrated

2

Below investment grade

1

 

The overall risks associated with a fund can be determined by looking at the cell in which it’s placed in the matrix. For instance, if a mutual fund is placed in the A-I cell, it means that it has the least risk potential.

How this new risk matrix differs from the existing risk-o-meter?

As mentioned, the new PRC risk matrix defines the maximum risk a debt mutual fund can assume in terms of both interest rate risk and credit risk. Hence, it helps an investor to understand the overall risks of a fund in a better manner. However, these risks may be potential and not present in the current portfolio.

The existing Risk-o-meter calculates the risks only based on the existing portfolio of the mutual fund scheme.

Under the new risk matrix, SEBI allows the investors to evaluate a mutual fund based on where it’s placed in a 9-cell matrix. Each debt fund is classified in the matrix as per the maximum interest rate risk and maximum credit risk it involves.

Also Read: Four benefits of investing in debt mutual funds

How can this new risk matrix help you make well-informed decisions?

  • The new PRC matrix allows you to select a suitable debt mutual fund based on your risk profile and investment horizon.
  • You can compare and evaluate mutual fund schemes within the same risk class.
  • The new matrix will increase the transparency as the fund houses won’t be able to assume more risks than stated in the PRC matrix.
 

To conclude

The new PRC matrix is expected to bring back the portfolio discipline among the Asset Management Companies (AMCs). It would improve disclosures and provide greater transparency to investors. More importantly, it will inform investors of potential risks that the fund may have.

It is crucial to look at a fund's placement in the matrix and evaluate the maximum risks it entails before deciding to invest in it.

Disclaimer – ICICI Securities Ltd. ( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100.  AMFI Regn. No.: ARN-0845. We are distributors for Mutual funds. Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. Please note, Mutual Fund related services are not Exchange traded products and I-Sec is just acting as distributor to solicit these products. All disputes with respect to the distribution activity, would not have access to Exchange investor redressal forum or Arbitration mechanism. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein mentioned are solely for informational and educational purpose.