A common instrument used by investors to evaluate the present degree of portfolio risk in a mutual fund scheme is the “risk-o-meter.” Every mutual fund scheme is required by SEBI requirements to have a risk-o-meter. Additionally, it has to be updated each month to reflect the scheme’s shifting risk levels.
But in addition to the present risk level, it is crucial for investors to understand the highest amount of risk fund managers is prepared to incur in the plan. For instance, if the fund management decides to include risky assets in the portfolio, a debt mutual fund that now has a “Moderate” risk profile on the risk-o-meter may eventually be labelled as a “High” risk scheme.
In order to invest wisely, investors need to be aware of the possible risk level associated with the plan.
The Securities and Exchange Board of India (SEBI) introduced a regulation in June 2021 requiring fund houses to tell Debt Fund investors of the maximum risk a debt scheme can assume. The regulation becomes effective on December 1. Under the new regulations, mutual funds will be required to classify their existing debt schemes and new debt schemes in a potential risk class (PRC) matrix based on the highest risk that the fund may incur in the future.
The purpose is to assist investors in debt funds in making informed decisions by informing them of the possible risks associated with the Debt Fund in which they have invested or intend to invest.
What Is The Potential Risk Class (PRC) Matrix?
The PRC matrix identifies the highest amount of potential risk that a debt mutual fund can jjassume. This regulation was implemented by SEBI on December 1, 2021, making it essential for fund houses to categorise all new and existing schemes under a potential risk class (PRC) matrix. This matrix requires debt funds to declare the maximum level of risk they are willing to assume in the future while managing the fund through its present and future investments.
Your debt mutual fund assets are always subject to credit risk and interest rate risk.
When an institution from whom a debt fund has acquired bonds defaults on principal or interest payments, the fund is exposed to credit risk. When such defaults occur, the value of the debt fund decreases. Alternatively, as bond prices and interest rates remain an inverse connection when interest rates are increased, bond yields decline, hence decreasing the scheme’s NAV. This occurrence is known as interest rate risk.
What Are The Different PRC Matrix Categories?
According to the PRC matrix rule, there are three categories of interest risk: Class I, II, and III, and three categories of credit risk: Class A, B, and C.
Class I schemes carry the lowest degree of interest risk, whereas Class III schemes carry the highest level of interest risk.
Likewise, if a debt plan is classified as Class A, it carries the lowest credit risk. If the plan is classed as Class C, it has the highest credit risk.
Combining the two results in a debt scheme with an A-I rating that has the lowest interest rate and credit risk level and a C-III rating that has the highest interest rate and credit risk.
How The PRC Matrix Uses Macaulay Duration And Credit Risk Value To Define Risk
To further understand how the potential risk class (PRC) matrix works, consider how Macaulay Duration and Credit Risk Value are used to calculate a fund’s interest rate risk and credit risk.
- Macaulay Duration Reveals A Fund’s Interest Rate Risk
The Macaulay Duration (MD) is the amount of time it takes for an investor to recoup the cost of a bond through interest payments and principal repayment. The Macaulay Duration of a bond is measured in years, and the shorter the MD, the smaller the bond’s potential interest rate risk. Bonds having a longer Macaulay Duration also have a larger interest rate risk.
A Debt Fund’s Macaulay Duration is the weighted average of the Macaulay Duration of each bond in which the fund has invested.
On the basis of the Macaulay Duration (MD) of the Debt Fund, each fund is categorised into one of three classes:
- Macaulay Duration (MD)-Based PRC Matrix Classification
| Class I | MD up to one year (residual maturity up to 3 years) | Debt funds with the least potential rate of interest risk |
| Class II | MD up to three years (residual maturity up to 7 years) | Debt funds with a moderate interest rate risk potential |
| Class III | Any MD | Debt Funds with highest potential interest rate risk |
Class I debt funds have the shortest MD and hence the lowest possible interest rate risk, whereas Class III funds have the most potential interest rate risk. The matrix also specifies the maximum residual maturity limit of the Debt Funds’ underlying investments. As a result, the residual maturity of the fund’s instruments with Macaulay durations of up to one year cannot exceed three years.
- Credit Risk Value is used to assess the fund’s credit risk.
SEBI has allocated Credit Risk Value (CRV) to various Debt Instruments in order to evaluate the possible credit risk of Debt Funds. Government securities have the greatest CRV since they have the lowest credit risk, according to the SEBI mandate, whereas bonds below investment grade have the lowest CRV. The table below displays the CRV of several types of debt instruments:
| Debt Instrument Type | Credit Risk Value (CRV) |
| Government Securities, State Development Loans, Repo on Government Securities, Tri-party Repos (TREPS), and Cash | 13 |
| AAA Rated Instruments | 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 weighted average credit risk value (CRV) of each investment in a debt fund’s portfolio is the fund’s CRV.
The PRC matrix divides a Debt Fund into the following groups based on CRV:
- Classification of the PRC Matrix based on Credit Risk Value (CRV)
| Class A | CRV must be 12 or above | Debt Funds with the lowest potential credit risk |
| Class B | CRV more than or equal to 10 but lower than 12 | Debt Funds with moderate potential credit risk |
| Class C | Less than 10 CRV | Debt Funds with the highest potential credit risk |
Debt Funds in Class A have the lowest amount of possible credit risk, while Debt Funds in Class C have the highest level.
How To Read The Potential Risk Class Matrix
The position of the Debt Fund on the potential risk class (PRC) matrix is determined based on the Macaulay Duration and the CRV, as indicated in the table.
| Maximum Credit Rate Risk of the Fund → | Class A (CRV More than 12) | Class B (CRV between 10 and 12) | Class C (CRV less than 10) |
| Maximum Interest Rate Risk of the Fund ↓ | |||
| Class I (MD up to 1 year) | Interest rate risk and credit risk are both relatively low (A-I) | Moderate credit risk and relatively low interest rate risk (B-I) | Low interest rate risk and high credit risk, respectively (C-I) |
| Class II (MD up to 3 years) | Interest rate risk is moderate, while credit risk is low (A-II) | Moderate credit risk and Moderate interest rate risk (B-II) | High credit risk and moderate interest rate risk (C-II) |
| Class III (Any MD) | High interest rate risk and low credit risk respectively (A-III) | High interest rate risk and moderate credit risk respectively (B-III) | High credit risk and relatively high interest rate risk (C-III) |
If a Debt Fund is rated A-I on the PRC matrix, it suggests it will avoid higher credit and interest rate risk. A C-III Debt Fund, on the other hand, may withstand higher interest rates and credit risk.
How Is PRC Matrix Different From Risk-o-Meter?
All factsheets for Debt Funds will be required to provide both Risk-o-meter and PRC Matrix data. Consequently, the Risk-o-meter offers investors a picture of the present risk associated with investing in the fund. In contrast, the PRC Matrix will assist investors in determining the future interest rate risk and credit risk that a Debt Fund is permitted to assume. Aside from this, the PRC Matrix also reveals the credit risk and interest rate risk of the Debt Fund individually, whereas Risk-o-meter provides a combined risk label based on numerous characteristics such as average maturity, etc.
Conclusion
As they are less risky than equity investments, debt schemes are added to portfolios to mitigate the total risk. Prudent investors would be dissatisfied if their hedging investments were riskier than anticipated in the future and added more risk to their portfolios.
Due to the inclusion of interest rate risk and credit risk, the highest limit of the risk an investor may be required to assume cannot be determined with precision. With the PRC matrix, however, it is now able to differentiate between debt funds with varying degrees of risk and make educated investment selections.
FAQs
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What Is Challenging About The PRC?
The purpose of providing the PRC is to inform you of the maximum risk a fund can accept. Therefore, while selecting funds, you are aware that they may incur greater risk than indicated by the Risk-O-Meter.
Firstly, some funds that might seem risky may not actually be! Take SBI or Aditya Birla Sun Life AMCs as an example. The liquid funds from these AMCs were not put in Class A, which is minimal credit risk, but rather in Class B, which is moderate credit risk. Given that liquid funds should have the lowest credit risk, you might be puzzled as to how this could possibly be the case. The justification is as follows: If a short-term instrument (with a short-term rating) also has a long-term rating, SEBI stipulates that only the lowest long-term rating will be taken.
For instance, the credit risk would be determined by the long-term AA rating of a commercial paper held by a liquid fund rather than the instrument’s real A1+ rating. If there is no long-term rating, the most conservative long-term rating will be used for a certain short-term rating based on the credit rating mapping of the rating agencies.
Short version: You shouldn’t be very concerned that ABSL’s liquid funds are in Class B because their short-term instruments have been determined to be creditworthy and the money is anticipated to be repaid in the near future.
Similar to the credit risk classification, the interest rate risk classification for a well-known fund like Aditya Birla Sun life Floating Rate is B-III, which signifies high interest rate risk and moderate credit risk. A-III is the same house’s gilt fund. Does this imply that, in terms of interest rate risk, the variable rate fund might be just as risky as the gilt fund? It’s unlikely since, like the gilt fund, the floating rate fund has merely identified itself as having “any Macaulay Duration.” But in practice, a variable rate fund behaves significantly differently from a gilt fund in terms of how it reacts to rate movements.
Second, choosing funds only on the basis of PRC may result in poor choices. For instance, whereas SBI Short Term Debt is in Class A and indicates minimal credit risk, Axis Short Term Debt is in Class B, indicating moderate credit risk. Actually, both funds have a history of having minimal credit risk, and Axis performs better across a wide range of performance indicators. Therefore, it might not be wise to choose funds just based on PRC.
Therefore, in addition to its possible conflict with its current Risk-o-meter, the Potential Risk Class matrix can become quite perplexing as a result of the anomalies mentioned above.
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How Should The PRC Be Used?
The PRC can offer you a good indication of the maximum risk that a fund is willing to accept. The wisest course of action is to avoid making a recommendation to purchase or to sell a fund solely based on this matrix for the reasons we discussed earlier. However hard SEBI may attempt to explain the risks, the conclusion is not straightforward.
Examining the present portfolio and conducting frequent reviews of the portfolio are the best ways to determine the risk of a debt fund’s holdings.
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