SEBI Introduces Risk Matrix to Classify Debt Schemes

Mutual Funds will soon classify debt mutual fund schemes through a new risk matrix based on credit risk and interest rate risk. It helps investors pick suitable debt funds to achieve short and medium-term financial goals based on their risk tolerance. According to the SEBI circular, mutual funds should compulsorily display a 9-level table or matrix for debt mutual fund schemes from December 01, 2021. It would show the interest rate risk and credit risk associated with debt mutual fund schemes. Why has SEBI introduced a new risk matrix for debt funds?

SEBI introduces new risk matrix for debt funds

You have many investors putting money in debt mutual funds without adequately understanding the investment. For instance, you may believe that investing in debt funds is safe. However, these funds may be exposed to both credit risk and interest rate risk. 

For instance, you have credit risk funds which are a type of debt mutual fund. They invest mainly in corporate bonds of a lower credit rating for a higher return. In simple terms, credit risk is the probability of suffering a loss as the borrower may default on the principal and interest payments. Many investors have lost money as they invest in credit risk funds without understanding the risk involved in the investment. 

Debt funds are also vulnerable to interest rate risk. For instance, debt funds may invest in bonds of a longer Macaulay Duration. It shows how long it takes to recover the price of a bond from its cash flows. However, debt funds that invest in bonds with a longer Macaulay Duration are vulnerable to interest rate fluctuations in the economy. 

For instance, the NAV of debt funds with bonds of a longer Macaulay Duration in the portfolio would fall when interest rates are expected to rise. SEBI has introduced the risk class matrix for debt funds so that investors in debt mutual funds can pick suitable investments based on their risk profile. Moreover, SEBI wants to highlight the risks a fund manager may take while managing a debt fund. For instance, debt fund managers cannot take risk beyond a predefined level which they have set.

How does SEBI’s new risk matrix for debt funds work?

According to SEBI rules, all debt fund schemes would be classified based on a potential risk class matrix. It consists of parameters based on the maximum interest rate risk and credit risk of the debt fund scheme. For example, the maximum interest rate risk is measured by the Macaulay Duration, and the maximum credit risk is measured by the credit risk value (CRV) of the debt fund scheme. 

You have the interest rate risk categorised into three buckets. The bucket Class I has a Macaulay Duration up to a maximum of one year. It will have debt instruments with residual maturity up to a maximum of three years. 

The Class 2 bucket has a maximum Macaulay Duration of three years. 

It has debt instruments with residual maturity of up to seven years. 

You also have the Class 3 bucket, which has a Macaulay Duration above three years. Moreover, the maximum residual maturity is not yet fixed for this class. 

You have the Franklin Templeton fiasco where the fund managers of debt funds invested in relatively risky debt to chase higher returns. The new matrix for debt funds helps investors identify the schemes in short duration buckets that hold maturity paper of higher residual maturity. It could lead to debt fund managers sticking to their investment mandate rather than chase high returns in risky fixed-income instruments. 

SEBI’s new risk matrix for debt funds has credit risk divided into three classes. You have credit risk value or CRV greater than 12, credit risk value greater than ten and CRV below 10. In simple terms, the credit risk value of the debt fund scheme is the weighted average credit risk value of each instrument in the portfolio. 

After a debt mutual fund scheme is placed in any particular cell, a change in the cell would mean a change in the fundamental attributes of the scheme. Investors may exit the debt fund scheme, which changes 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 the risk classification. 

You can understand the risk involved with debt funds after the introduction of the risk class matrix. It helps investors understand credit risk and interest rate risk involved with debt fund investments. Moreover, the new risk class matrix shows the risk taken by the debt fund manager to manage the investment.

For any clarifications/feedback on the topic, please contact the writer at cleyon.dsouza@cleartax.in