Mutual fund investments are subject to market risk, we all know.

But can the risk be mitigated through a prudent approach of managing investor's money?

The answer is, YES.

 

Just as equities are subject to market conditions and valua tions are volatile, fixed income too is subject to interest rate risk and credit risk. In interest rate risk, the degree of volatility varies with duration. Gilt funds carry a high interest rate risk and money market funds like liquid funds and ultra short-term funds carry relatively low risk. In the case of credit risk, bonds are assigned a credit rating through rat ing agencies based on their ability to finance debt obligations based on a thorough assessment of business metrics and available cash flows that can fund interest and principal repayments. AAA equivalent rating is considered to be of the highest quality with negligible risk on default on payment. Against the backdrop of recent credit linked developments which have impacted investors confidence in debt mutual funds, it is probably the right time for investors to understand the best practices of the fund management,

A. Maintain minimum cash level

To meet redemptions, an asset manager can maintain an overdraft position on a continuous basis. This is usually most common in liquid funds which have a higher exposure to CPs. This is followed to ensure that higher-yielding papers in the portfolio are not required to be sold to meet redemptions and instead, the bank borrowing lines are used to meet the redemption pressures. This practice exposes the fund to two types of risks;

Liquidity Risk

In a stressed liquidity scenario, the fund manager would find it difficult to sell CPs as they tend to become illiquid. A stressed liquidity scenario would be the exact time when the investors in a liquid fund are most likely to look to redeem.

Interest Cost

The interest cost of such overdrafts could become prohibitively expensive in a tight liquidity scenario.

Mandatory maintenance of a minimum overnight cash level of 10% in each liquid fund would ensure there is a prescribed level of liquidity to help meet redemption pressure. This is in line with the global best practices.

B. Ensure high-quality portfolio

Funds should focus on the highest credit quality exposure, which is defined by A1+ short term ratings. Any ratings lower than these could potentially expose the portfolio to liquidity risk in extreme market conditions. Globally, only the highest quality credits such as A1P1, which are the highest short-term ratings of S&P and Moody's, are eli gible for liquid funds. These ratings typically represent long term ratings of up to A or at best A-(Single A or single A-) on global rating scale.

The best short-term rating in the Indian context is A1+ translating into A+ rating in the long term.Only highest A1+ ratings would ensure the highest credit quality .

C. Make it Diverse

Since the objective of a liquid fund is to provide liquidity, safety and then returns, the requirement for diversification needs to be stronger as compared to other fund categories. Globally, regulation tends to follow a 5% or 10% single issuer norm, with funds typically having a 2-3% single issuer exposure.

D. Keep Less of Fixed Deposits

A fund manager is allowed to invest in bank fixed deposits up to 15% - 20% of the fund's NAV . The rationale of this guideline is to ensure that there is enough liquidity maintained in the portfolio to meet redemption pressure.

However, there's often a breach of this requirement by investing more in fixed deposits leads to benefit from the higher yield during quarteryear ends. Violation of this guideline defeats the purpose of investing in the fund.

Choosing the right debt fund need not be a complicated affair. Simple way to identify the right fund for your debt investment horizon is based on the four pointers.