Thread by @avasthiniranjan

Know your MF - A series explaining various important MF regulations that make them really sahi🙂

1st in this series let's understand one very recent regulation for debt mutual funds that classify their Potential Risk Class based on thier credit and interest rate risk.🚫

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Lets start with Debt MF 101📝

Debt funds have mainly 2 risks - Interest rate risk and credit risk🚫

Credit risk comes from downgrade or default in a bond amd impacts NAV📉

Interest rate risk arises from changing yields explained in more depth👇

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https://twitter.com/avasthiniranjan/status/1365980928036642816?t=G5d7kkZISnv4vrucn9Wuvg&s=1

Imagine you have invested in a short term fund which has a portfolio modified duration of 2.3 years and 100% investments in AAA rated bonds.

After 3 months you went and checked the portfolio and your were surprised😧 to see 30% exposure in AA rated bonds.

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Well, this is not what your signed up for. 🤨
The risk of the fund changed drastically without any information.😔

A similar shift in portfolio duration of a debt fund can completely alter the risk profile of your fund.

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Potential Risk Class (PRC) regulation announced by SEBI in June 2021 prevents such surprises and ensures that your debt fund doesn't shift its credit and interest rate risk profile drastically.🙂

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What is PRC matrix and how it is different from riskometer🤔

For investors to take informed decisions, there is a need to know...
a. current risk level as indicated by Risk-o-Meter and
b. maximum risk the fund manager can take in the scheme

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While the Risk-o-Meter stipulated by SEBI reflects the current risk of the scheme at a given point in time, PRC discloses the maximum risk a debt fund can take in the portfolio.⭐

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A Potential Risk Class matrix has 2 factors

1️⃣ maximum interest rate risk (measured by Macaulay Duration of the scheme) and
2️⃣maximum credit risk (measured by Credit Risk Value of the scheme).

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These 2️⃣ factors together make 9 categories in a 3x3 matrix and each scheme is placed in one of these cells that displays the maximum risk it can take.

See PRC matrix in the image 👇

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Interest rate risk in the above matrix is divided into 3 categories based on a threshold Macaulay Duration

1️⃣ Class I: MD<= 1 year
2️⃣ Class II: MD<=3 years
3️⃣ Class III: Any Macaulay duration

Class I means low risk from changing interest rates and III means it can vary.

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Credit risk in the above matrix is divided into 3 categories based on credit risk value calculated for the scheme. 🧮

Credit risk value is calculated by giving scores to each holding based on their credit rating.

Lower the score, higher is the credit risk in the fund.

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A credit score higher than 12 means the fund will invest in AAA and Sovereign rated bonds.

A score between 10 to 12 means some % of the portfolio will be invested in bonds rated AA+ and below.

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And a score below 12 means a sizeable % of the portfolio can be invested in low credit rated bonds and investors need to be very careful.🧐

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How to know the fund PRC positioning🤔

The position of the scheme in the matrix shall be displayed by the AMCs as under:

A short term fund with M. duration less than 3yrs and credit risk value more than 10 will be classified as B-II and showed on the matrix like this 👇

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How do you use the PRC matrix while choosing a debt fund🧐

1️⃣ Investing for very short term (less than a year)

Choose a fund with AI or BI which will have low interest rate risk and low to moderate credit risk👇

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2️⃣ Investing for short term (1 to 3 years)

You can choose any fund with AI, AII, BI & BII. These funds will have low to moderate interest rate and credit risk.

If you are comfortable with higher credit risk, only then funds in class C can be considered👇

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3️⃣ If you are investing for longer period then other categories can be considered.

Longer Target maturity funds will initially be placed in class III in terms of interest rate risk and hence, it is important to match your time horizon with such funds instead.

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The most important thing about PRC regulation...🧐

PRC defines threshold risk limits and if a fund which has placed itself in say AI wants to increase M duration of the portfolio above 1 yr or wants to take exposure to lower rated bonds, then it is not allowed to do so. 🙅‍♀️

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For a fund to do such change, it will have to do a fundamental attribute change in the scheme SID and inform all existing investors that it wants to change the positioning and also give them option to exit without any load, if any.

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This is the most important clause of the PRC regulation⚡

A fund cannot randomly change its portfolio which can alter its risk profile.

PRC makes sure that you get what you signed up for. It makes all debt schemes true to their label and sahi if you choose them correctly.

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So next time you when you are choosing a debt fund make sure you look at the PRC matrix and check if it matches with your investment objective. 😊😊

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