FundsIndia Views: SEBI’s new categories – what’s changing in your debt funds

Last week, we discussed changes in equity funds as AMCs get into full swing in redefining categories based on SEBI’s new rules. This week we’ll take up the changes involved in debt funds, what the impact of these changes are, and what you should watch out for.

Broadly, SEBI has defined new debt fund categories based on three criteria.

• On the credit quality of the portfolio. Therefore, there is a category stipulating that funds invest only in bonds that are AA+ and above and a category for funds that invest in lower-quality bonds.
• On the nature of instruments. For example, specific categories for investments in government bonds, floating rate instruments, money market instruments, banking & PSU debt instruments.
• On the duration or maturity of the portfolio. Here, SEBI uses a metric called Macaulay’s duration. This measures the average number of years taken for weighted discounted interest payments on a bond to equal the amount paid for the bond (i.e., the principal or the cost price). A bond’s Macaulay’s duration will always be lower than the bond’s actual maturity period. On duration, categories are split into smaller buckets such as less than 91 days, less than a year, 1-3 years and so on.

In total, there will henceforth be 16 debt fund categories. Up until now, debt categories are half that number (per our category definitions at FundsIndia). The important point in the new categorisation is this – a combination of the above is not used to define a category. Therefore, a category that is defined by duration does not mention any conditions on the credit quality that the fund can have. Likewise, a category defined by credit quality says nothing on what duration a fund needs to follow.

Where the new categorisation helps

On the positive side, the category definitions prevent funds from changing strategies based on market conditions. A short-term fund, for example, could include a share of long-term gilt papers to make money off rate cuts but which increases the duration and the volatility to a large extent. An income fund could change tactics during a rate cut cycle and slip into credit or into duration. This moving across maturities and absence of a steady strategy in many funds will now be addressed.

With that, let’s move into specific fund categories, what’s changed, and what is not. Our approach to debt funds has been based on the investor’s holding period or timeframe and the extent of the fund’s duration. The Select funds are also bucketed on these lines. The ‘old’ categories mentioned in the tables below are FundsIndia’s categories. The ‘new’ categories are those SEBI has defined.

For shorter term holding periods

By and large, funds that move to the new categories mentioned in the table may not need to change their strategies or portfolios by much. For example, existing short-term funds have portfolio maturities of 1-3 years and meeting the short duration category’s duration criteria should not be much of a stretch. Ultra short-term funds may need to make only slight adjustments where they move to the ultra short duration category since they already run average maturities of a year or less.

New categories introduced: Money market and floater funds are two new categories. While funds such as ultra short-term and liquid funds anyway invested in money market instruments, there was no exclusive category for these instruments. Funds in this category should invest in money market instruments with a maturity of up to 1 year and thus will be on par with today’s ultra short-term funds in terms of risk and return potential.

Floater funds need to maintain at least 65% in floating rate instruments. Floating rate instruments are debt papers where the coupon is variable throughout the tenure of the bond. Very few funds have slotted themselves into this category. The category requires a watch to see both performance potential and the type of investor requirement it suits. Floating rate instruments work best in rising rate cycles as coupon adjusts higher. There are floating rate funds today. However, they currently can invest in other instruments if such availability of these instruments is poor or do not offer adequate return potential. We would need to see how these funds manage different rate cycles.

What the risks are: As said above, SEBI’s definitions on duration do not make any mention of credit. Therefore, funds can run as they were before – i.e., short term and ultra short-term funds today take on low-rated credit papers to boost returns.

Today, short-term fund portfolios range from zero to 40% on an average in AA and below papers. By and large, it reflects in the portfolio yield-to-maturity. Similarly, in the new low duration category, there will be Principal Low Duration that has averaged 31% in low credit in the past year, a Tata Ultra Short with a 4% average credit exposure and an ICICI Pru Flexible Income with a 13% average credit exposure. In the new ultra short duration category, a high-credit L&T Ultra Short will jostle with Franklin India Ultra Short Bond’s 62% average credit exposure.

Therefore, returns and portfolio yields across the new debt categories will continue to mask the underlying credit risk of the fund. Credit risk in these categories will remain. As before, you will need to exercise caution in comparing funds as higher returns usually are associated with higher risks.

What we will do: We will continue to weigh credit quality, nature of instruments, concentration of high-risk instruments in the portfolio in our recommendations and in our ratings as we have been doing so far.

For longer term holding periods

Here, fund strategy changes are likely to be more significant than in the shorter-term categories. Categories defined by credit quality do not make a mention of duration. Categories defined by duration do not make a mention of credit. Gilt funds make no mention of duration. Therefore:

• Corporate bond funds will see a mix of portfolio duration. The funds moving to this category are a mix of short-term and long-term accrual funds. Aditya Birla Sun Life Short Term is today a short-term fund while HDFC Corporate Bond (erstwhile HDFC Medium Term Opportunities) is a longer term income fund. While funds moving to this category can continue to run the way they have been so far, they may explore playing with their maturities in different rate cycles.
• Dynamic bond funds moving to categories such as medium-to-long and long will have to rework their strategy to keep their duration within the restrictions given by SEBI. Aditya Birla Sun Life Income Plus, a dynamic bond moving to medium to long duration category, has seen maturity range from 6 to 15 years in the past two years. This freedom is now curbed for the dynamic bond funds moving to this category. Very few funds have moved to the long duration category.

What the risks are: Longer term debt funds come inherently with duration risks – that is, given their long maturities, they are more susceptible to changes in interest rates. This susceptibility reflects in the volatility of returns in shorter periods.

The risk in corporate bond funds is that they may change their duration based on the rate cycle even as they stick to top-rated corporate bond funds. So while they will be safe on credit, they may see short-term volatility from duration. Dynamic bond funds, of course, have duration risks as is the case today. Dynamic bond funds will be run as they are now.

In duration-based categories (first three in the table above), credit risk maybe a factor to look out for, as mentioned earlier for short-term funds. Consider medium duration funds, for example. Some funds moving into this category have taken low-rated credit earlier and can well continue to do so. Aditya Birla Sun Life Medium Term, Kotak Medium Term, UTI Medium Term, Franklin India Income Opportunities or Axis Regular Savings have had over 50% of their portfolio in papers below AA+ on an average. Likewise, funds that were lower on credit risk may continue in the same vein. L&T Resurgent India Bond, BNP Paribas Medium Term or IDFC SSIF-MTP, for example, have zero to less than 20% in low rated credit.

Therefore, credit risk in duration-based categories will remain. As before, you will need to exercise caution in comparing funds as higher returns usually are associated with higher risks.

What we will do: As said earlier, credit quality of funds is a factor we consider at all times and which we will continue to do. This apart, we will be watching strategies in categories such as medium-to-long duration to understand how funds will work within their restrictions to maximise returns. In corporate bonds, we will see if and how funds move around maturities to sustain performance across rate cycles, and how they use the small 20% leeway they have to invest outside high-rated corporate bonds.

What you should do

• If the funds you hold fit into your timeframe, simply continue to hold them. An ultra short-term fund becoming a low duration fund or vice versa will not unduly affect its suitability for you.
• If you are holding a fund for a shorter time frame of say less than 18 months and such a fund is moving into a longer-term category, check with your advisor on its suitability. For now, it appears that short-term debt funds have, at worst, moved to the corporate bond category. This is not a major cause for worry.
• Avoid being influenced by returns alone as they often mask risks in the portfolio.

Finally know this: A debt fund’s risk and return, and suitability for an investor, depends on the credit quality of its portfolio, its maturity and the extent to which this changes. SEBI’s categorisation of funds based on only one criteria and ignoring the others gives funds a good amount of freedom. Changes in fund strategies will not be apparent immediately or even in the next couple of months. Any changes – especially in categories such as corporate bond, credit risk, floater fund etc – will unfold slowly over time.

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis for investment decisions. To know how to read our weekly fund reviews, please click here.