How To Measure Risk In Debt Funds

In our previous issue, we discussed the various types of risks in debt funds. This time, we will discuss the Sebi-mandated methods for communication of the risk level in a fund. Like we have speedometers in cars, where the needle points to the speed, we have a risk-o-meter for mutual funds. This ‘meter’ is computed as per guidance given by the Securities and Exchange Board of India (Sebi), the regulatory body overseeing mutual funds. There are separate criteria for equity and debt funds, as the nature of the underlying risks are different.

There are three criteria for debt funds: (a) credit risk, (b) interest rate risk, and (c) liquidity risk. There are objective parameters for assigning a value to each of these risk aspects.

Briefly, for credit risk, there is a scale of 1 to 12, where 1 is for government securities and top-rated corporate bonds, and 2 is for AA+ rated bonds, and so on. The lowest point of the scale, 12, denotes below investment grade. Based on the weighted average value of each instrument, i.e., quantum of exposure to the instrument, the  credit risk value of the portfolio is assigned.

The interest rate risk value is assigned as per the Macaulay Duration of the portfolio, which measures the variability of returns from the fund as per changes in the interest rates. There is a scale of 1 to 6, where 1 is portfolio duration less than 0.5 years and 6 is duration of more than 4 years.

The third criterion, liquidity risk, is linked to the credit rating of the instruments. The reason is that the debt market is not very liquid beyond government securities and AAA-rated corporate bonds. Thus, trade data would not be a good parameter to measure liquidity. On the other hand, the higher the credit rating, the lower is the impact cost on selling. On a scale of 1 to 14 for liquidity risk, 1 is for government securities and top-rated corporate bonds, and so on.

Risk value for the debt portfolio is the simple average of credit risk value, interest rate risk value, and liquidity risk value. However, if the liquidity risk value is higher than the average of credit risk value, liquidity risk value and interest rate risk value, then the value of liquidity risk shall be considered as risk value of the debt portfolio. In other words, liquidity is a more important criterion. Finally, there is a scale given for assignment of the risk level where the needle of risk-o-meter will point. For a risk value of less than 1, it is categorised as low, for risk value of 1 to 2, it is low to moderate. It culminates with more than 5, which is very high risk.

Beyond The Risk-O-Meter

The risk-o-meter needle that tells you the risk level, low to high, gives you a ballpark indication of the volatility and credit risk in the fund. However, being just one number on a scale of 1 to 6, it can convey only so much. Preferably, you should get into a little more detail. For example, if the needle of the risk-o-meter points to high or very high risk in a fund, you would not know how much of it is from interest rate or volatility risk, and how much is from credit risk, etc. For that, you will need to scratch the surface. You can download the latest fund factsheet from the website of the asset management company (AMC). The basic principles remain the same; the higher the portfolio maturity/duration of a debt fund, higher will be the interest rate risk. The lower the credit ratings of instruments in the portfolio (against AAA), higher will be the credit or liquidity risk.

Another metric which you can track for a relatively better grasp of the risk level of a fund than conveyed by the risk-o-meter, is Potential Risk Class (PRC) matrix. The difference between risk-o-meter and PRC is that while the former is as per actual portfolio construct, the latter is “potential” as classified by the AMC. The AMC positions a fund under PRC, within the guidelines given by Sebi for categories of funds. There is a matrix specified by Sebi for PRC as well, where there are two variables. Interest rate risk is denoted by Class I, II and III, where Class I is portfolio duration of less than one year, II is duration between one and three years, and III is for duration of more than three years. Credit risk is denoted as A, which is best credit quality i.e., government securities/AAA rated bonds, B is just below A, and C stands for relatively inferior credit quality. As an example, if the AMC classifies a fund as AIII, it means the credit quality of the fund will be good (G-Secs/AAA), but can take interest rate or duration risk by increasing the portfolio maturity/duration. A fund with a PRC of  AI will be conservative in both the respects.

What Does It Mean For You?

If your objective is to have just a ballpark idea of the risk level in your fund, you can look at the risk-o-meter and PRC, which are conveyed through various fund literature. If you want to have a better perspective than the ballpark idea conveyed by the risk-o-meter and PRC, you should go a step further. Fund factsheets and portfolios are conveniently available on the websites of the AMCs, and the data will give you better clarity. Usually, people look at past returns before investing in a fund. While performance is important, understanding the risk you are getting into is as important. In debt funds, as compared to equity funds, there is a more objective assessment of the risk level. Volatility level in debt funds is relatively lower than in equity funds. However, there is a saying that there is nothing fixed in fixed-income funds, due to interest rate risk and credit risk. Therefore, it is necessary to do your basic due diligence.

The other aspect that would be of interest to you would be returns, because higher risk is supposed to be compensated with higher returns. In principle, if you are taking a higher interest rate risk or credit risk, then returns are expected to be higher. However, you may be caught in an unfavourable time phase. If you enter at a time when interest rates are going up (like it is now), the impact would be adverse. Similarly, in the credit default cycle of September 2018 to March 2020, debt funds faced credit events.  For interest rate risk, you have to remain invested in the fund for an adequate time horizon. The credit default cycle, hopefully, seems to be over.

The writer is a Corporate Trainer and Author