Understanding a debt fund is not rocket science

Retail investors are often at pains when they want to understand the risk profile of debt funds they are investing in. This exercise has assumed importance especially after recent losses in debt funds and the entire discussion on ratings of debt instruments and how mutual funds may have misread the risk of some bonds. While there is a fair bit of understanding when it comes to equity funds, debt funds remain a proverbial black hole for retail investors. Are there ways investors can check the underlying securities? How should investors interpret debt MF ratings? DNA Money spoke to MF experts to help you understand your debt fund better. Read on.

Credit risk, interest risk

When investing in debt funds, there are two main kinds of risks involved -- credit risk and interest rate risk. Credit events, like the IL&FS crisis, raise the importance of having high-quality assets in the portfolio, especially when one is investing for the short term. "Credit risk is the risk that investment in low credit rated securities may see a default or further downgrade. One example is IL&FS (incident). In interest rate risk, the fear is that bond prices may fall due to an increase in interest rates," says Abhinav Angirish, founder, Investonline.in.

A rise in interest rates means a decrease in bond prices, while a fall in interest rates means an increase in bond prices. "To offset the interest risk, fund managers may invest more in AA rated or lower rated investment instruments. This is a credit risk. The interest rate risk factor applies to all debt funds, although to varying degrees. However, the interest rate risk is relatively low for liquid funds," says Aditya Bajaj, head - investments & savings, Bankbazaar.com.

Jason Monteiro, AVP – MF Research & Content, Prabhudas Lilladher points out that funds with a higher duration are more sensitive to interest rate risks. In a rising interest rate environment, the value of longer maturity bonds falls by a greater margin than shorter maturity bonds. Funds with a duration of under three years have a low sensitivity to small fluctuations in interest rates. "Thus, investors in funds with a maturity under three years, such as liquid funds, money market funds, ultra-short duration funds, low duration funds, and short duration funds, need to understand the credit quality of the underlying portfolio. They need to check if the fund manager is investing in lower-rated securities to generate a higher yield," he says.

Those investing in debt funds with a duration above three years, the Net Asset Value is threatened by both the interest rate movements and the credit quality of the portfolio. Thus, in a rising interest environment, investors need to be cautious before investing in higher maturity bond funds, Monteiro added.

Risk profile, ratings

If you feel confused by too much information, there is a short-cut. Kaustubh Belapurkar, director of fund research, Morningstar Investment Adviser India says an easier method would be to simply look at the Morningstar Fixed Income Style Box for each fund at www.morningstar.in.

The Morningstar Fixed Income Style Box is a graphical representation through a nine-grid box that classifies each fixed income fund for Interest Rate Sensitivity and Credit Quality.

Interest rate sensitivity is classified in three buckets (limited, moderate & extensive) on the horizontal axis. Credit quality is also classified in three buckets (high, medium & low) on the vertical axis.

One look at the Style Box can help an investor understand the interest rate risk and credit risk a fund carries. "As a rule of thumb 'limited' interest rate sensitivity means lower interest rate risk and high credit quality means lower credit risk," says Belapurkar.

Ratings of underlying securities can be found in the fund factsheet or the portfolio disclosure on the fund's website. "Things for any company can change quickly, but despite this, ratings are actually a good indicator of credit health of a portfolio. The investor must consider it but should not completely rely on it," advises Angirish.

Investors seeking extremely low credit risk should pick schemes with an allocation of over 95% to bonds rated 'AAA' and above, remarks Monteiro.

Agencies like CRISIL give credit rating to the fund. Fund tracking organisations like Value Research also give fund ratings to debt MFs. Value Research Ratings are given as stars (one star to five stars) for risk-adjusted performance of a fund relative to their peers. These ratings are based on historical returns and are a good starting point for a fund evaluation. They are not a prediction of the future.

Concentration of portfolio

Keep an eye on concentration in debt MF portfolio. This the proportion of holdings an investor has in one specific bond. The higher the holdings in a certain bond, the higher the risk. "A debt fund scheme needs to be 'liquid' enough so that it can comfortably manage large value redemptions without adversely impacting the NAV of the scheme," says Bajaj.

Maturity period, yield, expense ratio

A retail investor should first consider time horizon while investing and then choose a fund category that suits his risk appetite and time horizon the best. Those having an investment horizon of less than six months and between six and 12 months should invest in ultra-short duration and low duration funds respectively.

The new Sebi categorisation help investors identify weight given to AAA rated, sovereign and quasi-sovereign instruments in the underlying portfolio of debt scheme. For example, corporate debt funds have been mandated to invest at least 80% of their corpus in highest rated corporate bonds, whereas a credit risk fund has to invest at least 65% of its portfolio in below highest rated instruments.

Once an investor selects appropriate fund category, he/she should take a quick look at various fund portfolios within the category and check their average maturity period, modified duration, yield to maturity and expense ratio, says Naveen Kukreja, CEO & co-founder, Paisabazaar.com.

Average maturity is the weighted average of the residual maturity of all debt instruments held by debt fund. Modified duration denotes sensitivity of fund's portfolio to interest rate changes. Higher the average maturity and modified duration of a fund, the higher would be its sensitivity to interest rate changes, says Kukreja.

The yield-to-maturity (YTM) of a debt fund is the weighted average yield of its portfolio constituents. As it gives a fair idea about the interest income that can be earned from the portfolio, investors should compare YTM of the debt fund its peer funds and other safer fixed income instruments.

"Remember that YTM is not a definite indicator, as the actual fund return would also depend on the mark-to-market valuations and changes in the portfolio," adds Kukreja.

Expense ratio is the percentage of the fund's total assets used to meet its total expenses. As the expense ratio would reduce the effective yield of the debt fund's portfolio, a higher expense ratio would translate to lower effective yield. Investors should prefer direct plans as their lower expense ratio would translate to higher effective yield, notes Kukreja.

Many feel an investor is better served by simply looking at the daily NAV of the fund which reflects the movement in prices of the underlying bond holdings of the fund. "A simple graph of the NAV growing over time should do. The interest income earned by the fund will be reflected in the upward slope of that line. The kinks in that line represent the mark to market risk. The time taken for those kinks to even off indicates how long it takes for recovery from any market loss. So, smoother the line, lower the line, lower the kinks, and faster the recovery, less risky the fund," advises Bajaj.

WHAT TO LOOK FOR IN THE FACT-SHEET

• Look at ratings of the securities the fund invests in - higher the rating, safer is the security and, hence, the fund
   
• Higher the average maturity and modified duration of a fund, the higher would be its sensitivity to interest rates
   
• YTM gives a fair idea about the interest income that can be earned from the portfolio