Debt fund investors have been at the receiving end of errors of omission and commission by their fund managers, in the form of cuts in net asset values (NAVs) as debt instruments were downgraded or issuers defaulted, fund houses limiting redemptions and, in extreme cases, funds closing down. In a bid to make debt funds more transparent, the Securities and Exchange Board of India (Sebi) and the Association of Mutual Funds in India (Amfi) recently came out with guidelines on additional disclosures on portfolio features that funds need to make to investors.
Investors can now use the information to better assess if a scheme’s risk profile matches their requirements. Here is what you should watch out for.
Yield to maturity
To be disclosed in monthly factsheet: Use the yield to maturity (YTM) of the portfolio as an early warning system to understand the risk and return from the fund and to track changes in the same. While using YTM net of expenses as an indicator of returns has limitations since it does not consider the impact on the returns from a change in YTM when securities are bought and sold, it is a number that can give meaningful insights into the portfolio itself.
A high YTM in a fund relative to its peers with similar portfolio duration may indicate a portfolio with a lower credit quality. Bonds with lower credit rating have to offer higher yields to compensate the investors for the higher risk of default they are taking.
Evaluate high YTM portfolios for the risks. Check the size of holdings in individual lower-rated securities since a large exposure will impact the fund significantly even if one issuer defaults. Similarly, lower-rated securities have less liquidity and this can affect the ability of a fund to meet redemptions if a large portion of the portfolio is in such securities.
Keep an eye on change in YTMs. While an increase in YTM may be the result of an overall change in market yields or liquidity conditions, it typically indicates a deterioration in the portfolio quality and should be seen as a red flag. “Small changes of a few basis points in yield should not be a cause for worry but if there is a large shift, say the YTM moves from 8% to 8.25% or higher, then one needs to look at the quality of the paper and the overall economy,” said Vikram Dalal, managing director of Synergee Capital Services Pvt. Ltd.
Macaulay’s duration, modified duration and average maturity of the portfolio to be disclosed in the factsheet: Use these measures to gauge the extent of risk and align it to your goals.
While Macaulay’s duration of the portfolio helps slot the fund into the various categories defined by Sebi, the modified duration that is derived from it is a measure of how much the portfolio value will be impacted by a change in interest rates. A 1% increase in rates will mean an approximate loss of value of 2% in a portfolio with a modified duration of 2. A decrease in interest rates will lead to a gain in portfolio value to around the same extent. “To evaluate the extent of volatility in a debt fund, the modified duration should be the number to look at,” said Avnish Jain, head of fixed income at Canara Robeco Mutual Fund.
Looking at the portfolio duration in conjunction with the average maturity in a debt fund can show up portfolio management practices that may add to the risk. “If there is a significant divergence between average maturity and duration in a portfolio, it may indicate that the fund house is holding some long-tenor bonds in an otherwise short-duration portfolio and running a barbell kind of strategy. The impact on the portfolio will be higher if interest rates move adversely,” said Jain. The divergence will show up more in the average maturity of the portfolio rather than the duration.
Two bond portfolios may have similar average maturities but their durations may be different. This may be because the quality of the instruments held in each are different. Lower-rated portfolios, typically, have lower duration. For example, Axis Short Duration fund has an average maturity of 2.4 years and ICICI Prudential Credit Risk fund has an average maturity of 2.41 years. But the modified duration of the Axis fund (AAA-rated portfolio) is 2, while that of the ICICI fund (pre-dominantly AA-rated portfolio), is 1.77.
Perpetual or At1 bonds
To be clearly identified in the portfolio: Use this information to assess if there is lurking risk from perpetual bonds such as additional tier I bonds issued by banks. An instrument issued by a bank may appear to have the highest degree of safety, but the terms of issue of these unsecured bonds allow the bank to default on payment of interest and even write down the principal, if specified conditions apply, increasing the default risk.
Moreover, perpetual bonds have no maturity at the end of which the principal is returned. There are call options in these, typically at the end of five or 10 years, which allow the banks to call back the bonds and cancel them but banks may choose not to do so.
“A portfolio that has more of tier I bonds are riskier than those that have tier II bonds since these bonds, unlike tier I bonds, have a fixed maturity of 10 years with a call option after five years. The risks make these bonds unsuitable for retail debt portfolios like mutual funds where the investors are looking for stable returns with minimal risk to capital,” said Dalal.
To be made every fortnight instead of every month: Use the increased frequency to keep track of the fund’s securities.
“It may put an end to the practices of portfolios running higher durations and other measures to shore up yields and then present a different picture at the end of the month by putting through inter-scheme transfers,” said Jain. These practices increase the risk without the knowledge of investors.
Additionally, the YTM of each security will now be provided that will help track changes in their credit quality. A deterioration in the market’s perception of credit risk will translate into lower prices for the bond and higher yield and vice-versa. Use this information to gauge the extent of risk in a portfolio on account of exposure to a particular security.
With regulators making greater disclosures necessary for fund houses, it is up to the investors and advisers to make periodically tracking portfolios a necessary part of investing in debt funds.
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