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In a circular issued by the capital markets regulator, SEBI, came out with a risk classification matrix for debt mutual funds, which take into account both credit and interest rate risk. This new risk matrix addresses a long-standing gap in the regulations that permitted fund houses to have high credit risk paper in debt schemes defined just by duration.
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Mutual funds, in future, will classify debt mutual fund schemes through a risk matrix based on credit and interest rate risk. It allows investors to choose suitable debt funds to get short and medium-term financial goals based on their tolerance of risk.
As per the circular issued by the SEBI, mutual funds must mandatorily display a 9 level table or matrix for debt mutual funds schemes beginning from 1st Dec 2021. It would display the interest rate risk as well as credit risk associated with the debt mutual fund schemes.
There are a lot of investors who put their money in debt mutual funds without precisely understanding the investment. E.g., you may think that investing in debt funds is safe, but these funds could be exposed to both credit and interest rate risk.
If you have credit risk funds which are like debt mutual funds, mainly invest in corporate bonds of a lower credit rating for a high return. In simple words, credit risk is the probability of incurring a loss as borrower may default on the principal and interest payments. Many investors have incurred losses as they invest in credit risk funds without knowing the risk involved in the investment.
Debt funds are also exposed to interest rate risk. E.g., debt funds invest in bonds of a longer Macaulay duration. It shows how long it takes to get the price of a bond from its cash flows. However, debt funds that invest in bonds with longer Macaulay duration are exposed to interest rate up and down in the economy.
The Securities and Exchange Board of India has introduced the risk class matrix for debt funds in order for the investors in debt mutual funds can choose suitable investments based on their risk profile. Also, SEBI wishes to highlight the risk a fund manager may take when managing a debt fund. Debt fund managers may not take risk beyond a predefined level which they set.
As per SEBI rules, all debt funds schemes will be classified based on the potential risk class matrix. It comprises parameters based on the maximum interest rate risk and credit risk of the debt fund scheme. The maximum interest rate risk is measured by the Macaulay Duration and the maximum credit risk by the credit risk value of the debt fund scheme.
The interest rate risk is categorised into 3 buckets. The bucket Class I has Macaulay Duration of up to maximum 1 year. It shall have debt instruments with residual maturity up to a maximum of 3 years period.
The class 2 bucket has a maximum MD of 3 years. It shall have debt instruments with residual maturity of up to 7 years.
Then you have the class 3 bucket, which has a MD of more than 3 years. The maximum residual maturity is not fixed yet for this class.
As happened in the Franklin Templeton fiasco, the fund managers of debt funds invested in relatively risky debt to chase higher returns. The new matrix for debt funds will assist investors to identify the schemes in short duration buckets that hold maturity paper of high residual maturity. It may lead to debt fund managers sticking to their investment mandate instead of chasing higher returns in risky fixed income instruments.
SEBI’s new risk matrix for debt funds has divided credit risk into 3 classes. Credit risk value greater than 12, credit risk value greater than 10 and credit risk value below 0. In simple words, the credit risk value (CRV) of the debt fund scheme is the weighted average credit risk value of each instrument in the portfolio.
Once a debt mutual funds scheme is placed in any cell, a change in the cell would indicate a change in the fundamental attributes of the scheme. Investors can exit the debt fund scheme, which will change the cell without incurring an exit load as the fundamental attributes have changed. However, SEBI has made allowances for mutual funds that hold perpetual bonds of banks during risk classification.
One can understand the risk involved with the debt funds once the risk class matrix is introduced. It assists the investors in understanding the credit risk and interest rate risk involved with debt fund investments. The new risk class matrix also shows the risk taken by the debt fund manager to manage the investment.
SEBIs circular stated that mutual funds must mandatorily display a 9 level table or new risk matrix for debt mutual funds schemes beginning from 1st Dec 2021. It would display the interest rate risk as well as credit risk associated with the debt mutual fund schemes.
Read our Article: Analysis of Amendment in SEBI Guidelines for Investment Advisers
Ashish M. Shaji has done his graduation in law (BA. LLB) from CCS University. He has keen interests in doing extensive research and writing on legal subjects especially on corporate law. He is a creative thinker and has a great interest in exploring legal subjects.
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