‘PRCM has defined the boundaries for fund managers of debt schemes’

By May 13, 2022DeFi
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A key concern for most retail investors before investing in markets is whether it is safe. This concern is genuine and fair, especially when seen in the context that today's retail investors are looking for avenues beyond fixed deposits. Given this chief concern, even the regulator--Securities and Exchange Board of India (SEBI)--has been alert and careful about ensuring that investment avenues available in markets are safe for investments especially from the point of view of retail investors. Take for instance, debt funds. In the recent past, a series of regulatory moves have helped investors to make informed decisions while selecting a debt fund one such key measure announced by SEBI is Potential Risk Class Matrix (PRCM). PRCM helps you gauge risks and invest in clearer way in debt funds. But experts and analysts point out that not many retail investors are aware of this measure and its advantages. Let us understand how PRCM helps you to understand risks associated with debt funds and invest better in these funds.

A debt fund is exposed to two key risks--credit and interest rate risk. Credit risk means the default risk – a situation where an issuer of a bond fails to pay the interest or repay the capital as agreed at the time of issue of the bond. The interest rate risk is a bit more complicated. When the interest rates (and bond yields) rise, bond prices go down. The other way round also holds good. Hence, when interest rates rise, bonds held in a portfolio of a debt scheme bookmark-to-market losses. If the duration of a bond portfolio is high, then interest rate risk is even higher. To put it simply, for long-term bonds the impact of changes in interest rate is high.

Now with these two risks in mind, let us consider a situation of investing in a debt fund. You are invested in a debt scheme which has invested all its money in AAA-rated bonds with 2.3-year duration. After three months you come to know that your portfolio composition has now changed. Now the scheme has allocated approximately 30 per cent of the money to AA rated (relatively high risk compared to AAA-rated bonds) bonds and the duration of the scheme has also gone up to four years. This can be a classic situation of your investment turning riskier.

To avoid such jolts, SEBI introduced the concept of PRCM in June 2021 which was implemented from December 1, 2021. PRCM is a framework of risk-levels built after taking into account the various levels of credit risk and interest rates a debt fund can take. Before we understand it in greater detail, let us know the difference between risk-o-meter and PRCM. While the former tells you how much risk a fund manager has taken at the end of the previous month, the latter tells you how much risk a fund manager can take.

Now let us turn to PRCM. PRCM has nine cells denoting various levels of risks as shown in the previous chart:

Interest rate risk is shown on the vertical (left) hand side and has three levels- I) Macaulay Duration (MD) of less than one year, II) MD of less than three years, and III) MD of more than three years. Credit risk is shown on the horizontal (top) side and has three levels. The risk level is measured by credit risk value (CRV) – A) CRV of more than or equal to 12, B) CRV of less than or equal to 10 and C) CRV of less than 10.

CRV is computed by giving a score to each bond depending on the credit rating it has. While government securities and AAA rated bonds have scores of 13 and 12 respectively. Bonds with A+ rating and bonds with A rating have 7 and 6 scores respectively. As we move down the ratings the score goes down. If a scheme allocated more money to bonds with high ratings its CRV goes up and vice versa.

Depending on these three levels, each of interest rate risk and credit risk, there is a 3X3 matrix, which gives us nine cells from AI, AII to CIII. While AI means least credit risk and least interest rate risk, the CIII means the highest level of credit risk and the interest rate risk. For example, a debt fund placed in BII cell means moderate credit risk and moderate interest rate risk. Each fund house decides where it wants to place each of debt schemes. More than one debt scheme can be placed in one cell.

But what if after placing a scheme in a particular cell, a fund manager wants to take more risk. For example, a scheme was placed into AI cell. Now the fund manager wants to increase the duration to two years and wants to invest in AA-rated bonds. In such a situation the fund house has to complete the process prescribed for change in fundamental attribute. This is the defining feature of PRCM which also makes it a cornerstone of risk management for investor. A fund house cannot complete this process overnight. It has to obtain NOC from SEBI, issue a notice to all unit holders informing them about the change in PRCM in scheme information document and give them a month's time to exit the scheme, without exit load, if any.

All this sounds good. But the moot question is how to use it to your advantage as an investor. If you are investing for a very short term (less than one year), then it is prudent to stick to schemes placed in cells AI and BI which have relatively low interest risk and relatively low to moderate credit risk. If you want to invest for a short term (one to three years), then you can consider investments in schemes placed in AI, AII, BI and BII cells which have relatively low to moderate interest risk and low to moderate credit risk. If you are investing for longer duration, then consider investing in schemes placed in AIII and BIII cells. Schemes placed in CI, CII and CIII connote high credit risk Considering these facts, PRCM has defined the boundaries for fund managers of debt schemes. Experts point out that a key thing this measure has done for investors is it has helped them make an informed call about risk-reward involved in a debt fund.

(The author is the Head – Product, Marketing & Digital business at Edelweiss Asset Management Limited (EAML).

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