A debt fund is exposed to two key risks: credit risk and interest rate risk. Credit risk refers to the risk of default – a situation in which the issuer of a bond does not pay interest or repay principal as agreed upon when the bond was issued. Interest rate risk is a bit more complicated. When interest rates (and bond yields) rise, bond prices fall. The reverse is also valid. Therefore, when interest rates rise, bonds held in a portfolio of a debt program mark losses relative to the market. If the duration of a bond portfolio is high, the interest rate risk is even higher. Simply put, for long-term bonds, the impact of interest rate changes is high.
Now, with these two risks in mind, consider a debt fund investment situation. You are invested in a debt scheme that has invested all of its money in AAA rated bonds with a duration of 2.3 years. After three months, you learn that the composition of your portfolio has now changed. Today, the scheme has allocated about 30% of the money to AA-rated bonds (relatively high risk compared to AAA-rated bonds) and the duration of the scheme has also increased to four years. This can be a classic situation where your investment becomes more risky.
To avoid such jerks, 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 different levels of risk of credit and interest rate that a debt fund can take. . Before understanding it in more detail, let us know the difference between risk-o-meter and PRCM. While the former tells you how much risk a fund manager took at the end of the previous month, the latter tells you how much risk a fund manager can take.
Now let’s move on to the PRCM. The PRCM has nine cells denoting different levels of risk as shown in the previous graph:
Interest rate risk is shown on the vertical (left) side and has three levels: I) Macaulay Duration (MD) less than one year, II) MD less than three years, and III) MD more of three years. Credit risk is displayed on the horizontal side (top) and has three levels. The level of risk is measured by the Credit Risk Value (CRV) – A) CRV greater than or equal to 12, B) CRV less than or equal to 10 and C) CRV less than 10.
CRV is calculated by assigning a rating to each bond based on its credit rating. While government securities and AAA rated bonds have scores of 13 and 12 respectively. A+ rated bonds and A rated bonds have 7 and 6 scores respectively. As we go down the grades, the score goes down. If a system allocates more money to bonds with high ratings, its CRV increases and vice versa.
Based 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 signifies the least credit risk and the least interest rate risk, the CIII signifies the highest level of credit risk and interest rate risk. For example, a debt fund placed in cell BII means moderate credit risk and moderate interest rate risk. Each fund house decides where it wants to place each of the debt schemes. More than one debt scheme can be placed in a cell.
But what if after placing a scheme in a particular cell, a fund manager wants to take on more risk. For example, a diagram has been placed in cell AI. 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 must complete the prescribed process for the fundamental attribute change. This is the defining feature of PRCM which also makes it a cornerstone of risk management for the investor. A fund house cannot complete this process overnight. It must obtain a NOC from SEBI, issue a notice to all unitholders informing them of the change in PRCM in the plan’s information document and give them a period of one month to exit the plan, without an exit charge, if applicable.
It all sounds good. But the debatable question is how to use it to your advantage as an investor. If you are investing for the very short term (less than a year), it is prudent to stick to plans placed in the AI and BI cells which have relatively low interest rate risk and relatively low credit risk. to moderate. If you want to invest for the short term (one to three years), you can consider investments in devices placed in AI, AII, BI and BII cells which have relatively low to moderate interest risk and low credit risk. to moderate. If you are investing for a longer term, consider investing in plans placed in cells AIII and BIII. Schemes placed in CI, CII and CIII connote a high credit risk Considering these facts, the PRCM has defined the limits for fund managers of debt schemes. Experts point out that a key thing this measure has done for investors is that it has helped them make an informed call on the risk-reward trade-off involved in a debt fund.
(The author is Head of Product, Marketing and Digital Business at Edelweiss Asset Management Limited (EAML).