Role of Credit Ratings in Debt Mutual Fund Selection

Here’s a few points on the Role of Credit Ratings in Debt Mutual Fund Selection:

Role of Credit Ratings in Debt Mutual Fund SelectionFor Bangalore-based Srikanth Prabhu, 2016 was an eventful year. His debt funds yielded a return of as high as 12-14%. Conversely, his fellow investors in other AMCs were facing bleeding debt portfolios due to volatile interest rate environment.

He was satisfied with his decision to stick to this AMC. After all, he was earning much more than the little 8-8.5% returns on fixed deposits. He expected this rally to continue for a relatively extended period.

One fine day everything came to a standstill. To his surprise, his debt portfolio lost as much as 7% in a single day. That too, for no fault of his. He had been pretty confident about his debt fund selection. The fund managers were quite experienced. He couldn’t believe how this could happen all of a sudden.

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Upon scrutiny, he realised that the fund manager had invested in a low-credit-rated commercial paper. The company defaulted on its debt servicing obligations, and its rating was downgraded. Consequently, the entire investment of Srikanth went for a toss.

Srikanth’s is not a standalone case. Instances like these have occurred more than once in the MF domain.

Now the question is “Why did this happen?”

Inclusion of Low-credit rated debt securities

Debt funds can add immense value to your portfolio if chosen diligently. Debt funds are capital preservation products. You are drawn to them owing to low-cost structure and stable returns. Moreover, these need to be highly liquid and score higher on post-tax return.

The problem lies wherein investors get totally relaxed as regards investment risks. Like every other investment, debt funds are exposed to their set of risks. Investors’ think that a debt fund portfolio remains immune to the external dynamism.

In reality, this is not what happens.

Debt funds are immensely affected by volatile interest rate regime. An increase/decrease in interest rates changes bond prices and yields. It ultimately impacts the fund returns.

In the above scenario, fund manager was under constant pressure to deliver returns in line with investor expectations. Modifying interest rates was beyond his control. The only way out was to compromise on the credit quality of securities.

The fund manager, thus, invested in low-credit-rated debt instruments. These havens, owing to high-risk of default, bear higher coupon rates. In this way, he was able to keep the fund returns in line with the expected returns.

The investors were unaware of these adjustments being carried out in the background. They couldn’t even imagine identifying this folly in the portfolio holdings.

Even if some of them were aware, they would have become short-sighted. At times, during MF investing, this is the biggest mistake which investors may commit. Instead of becoming goal-oriented, they may get too much return-conscious. They might lose sight of the larger picture.

If you too happen to prioritise returns over credit-ratings, then be prepared for such financial disasters.

Also read: Should you be investing in international equities

Mutual Fund Credit Ratings

A credit rating explains about the credit risk inherent in the borrowing entity. Such a rating can be assigned to other entities like an individual or a sovereign government. It is an analysis of the creditworthiness of the borrower. The credibility relates to servicing of a debt or a financial obligation.

The credit rating is derived from credentials of the entity issuing the instrument. The credentials can be the statement of assets and liabilities of the entity. A detailed financial history of borrowing may also be referred.

In the case of debt fund schemes, additional factors may be considered. Parameters like credit quality of individual assets, diversification of the portfolio, management quality and operational policies may form part of analysis.

The credit ratings are given by credit rating agencies (CRAs) like CRISIL, ICRA, CARE, etc. The rating agency wants to determine the likelihood of default of the MF scheme. An assessment is made whether the scheme would repay the invested principal/interest as it falls due.

A high credit rating indicates that you will get back the interest and principal invested in that security on time. Conversely, poor credit rating conveys an adverse situation. It suggests that the scheme might default on repayment at maturity.

Factors affecting Credit ratings

There are a lot many factors that affect credit ratings of debt fund schemes. The primary factor to be considered is the timely payments from investment the scheme has made. Any missed payments or defaults results in lowering of credit ratings.

Another factor can be the economic outlook of the entity. A positive outlook in future leads to an increase in the rating by the agency. A negative outlook like a decrease in future cash flows may lead to a rating downgrade.

How to use credit ratings in Debt fund selection

The credit ratings represent current opinion of the respective rating agency regarding credit risk of debt fund schemes. These ratings can be used to assess the creditworthiness of INR denominated debt obligations. You may use these to draw a relative comparison among competitive debt fund schemes.

The rating scale used to assign rating depends on the duration of the particular scheme. You may find a long-term scale for open-ended schemes. The same scale is also used for close-ended scheme having the maturity of more than one year.

You may refer to short-term scale to analyse close-ended schemes having the maturity of less than one year. Remember that the ratings assigned are very dynamic in nature. These may change or be terminated based on market developments.

Earlier there used to be variation in the ratings assigned by different credit rating agencies. It created a lot of confusion among the investors. The entire process became extremely chaotic. In 2011, SEBI asked the CRAs to formulate a standard rating symbol.

You may find the latest rating symbols in the table below:

Role of Credit Ratings in Debt Mutual Fund Selection

In the case of long-term debt schemes, AAAmfs carry the highest degree of safety. AAmf and Amf have a high and adequate level of safety, respectively. As regards BBBmfs and BBmfs, these schemes carry moderate risk. A Bmf-rated debt fund scheme has a high degree of risk. Finally, scheme carrying Cmf rating has the least degree of safety.

Additionally, CRAs may use the ‘+’ or ‘-‘ symbol along with the rating. It reflects the comparative standing of the debt fund scheme within the category.

In the case of short-term debt fund scheme, carry the highest degree of safety. A2mfs and A3mfs ratings reflect a robust and moderate degree of safety, respectively. A4mfs ratings carry a very high level of risk.

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Choosing between Prudent Fund Management vs. Performance

Often you might be caught in two minds when it’s about debt fund investments. Whether to choose prudent fund management or performance! But to stay afloat, you need to be rational. You need to be concerned about the returns. But simultaneously, you should not lose the focus on your goals. When you have to travel distances, you need to be resourceful. Hence, choosing Prudent Fund Management over Performance pays well in the long-term.

Give due consideration to credit ratings while selecting debt funds. Moreover, keep track of rating downgrade and upgrade in your fund portfolio.

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