How PRC Matrix of Debt Mutual Funds Works?

If debt mutual funds are part of your portfolio, you must have received an email or an SMS from the fund house on or after 1st December 2021 disclosing the risk class of your debt fund.

While many investors were largely confused, this was just a disclosure and not a call to action. Let's understand what it was about.

PRC Matrix Introduction

In December 2021, SEBI made it mandatory for all the fund houses to have a Potential Risk Class matrix (PRC matrix) and ensure appropriate disclosure of it. This was an attempt from SEBI to promote investors' safety as this PRC matrix would facilitate investors to make informed decisions. 

One might argue about the need for a PRC matrix when we already have a riskometer at our disposal. 

While the riskometer considers only the current risks associated with the mutual fund and is updated only after a month, a PRC matrix lends a futuristic view. It gives the highest level of risk that cannot be breached by the mutual fund. 

Let us understand the PRC matrix in more detail.

What is a PRC Matrix? 

PRC matrix defines the extreme level of potential risk a debt-mutual fund can take. SEBI brought this regulation into effect on December 1, 2021, which makes it mandatory for fund houses to classify their new schemes as well as the existing schemes in a potential risk class (PRC) matrix.

This matrix asks debt funds to specify the maximum degree of risk they are willing to undertake while managing the fund in the future through their current and future investments. 

Your investments in debt mutual funds are always exposed to credit risk and interest rate risk. 

Credit risk is encountered when the debt fund suffers defaults in the principal or interest payment from the institutions they have purchased bonds from. In case of such defaults, the value of the debt fund declines.

On the other hand, since bond prices and interest rates maintain an inverse relationship when interest rates are hiked, bond yields slump, bringing down the NAV of the scheme. This phenomenon is called interest rate risk. 

Categories of PRC Matrix

There are three categories of interest rate risk and credit risk. 

The three categories for interest rate risk are Class I, Class II, and Class III, while the three credit risk categories are Class A, Class B, and Class C.

Debt fund schemes that are classified as Class I carry the lowest interest rate risk, and those classified as Class III bear the highest interest rate risk. Similarly, credit rate risk schemes classified as Class A have the lowest risk, and those classified as Class C carry the highest credit risk.

The risk associated with debt funds is always assessed as an interest rate risk and credit risk combination; thus if we combine the two, a scheme classified as A-I carries the lowest interest rate and credit risk, while a scheme with a C-III classification carries the highest. 

PRC Matrix Criterion to Categorize Debt Funds

Now that we know the risk categories, let's find out how a PRC matrix categorizes different debt schemes. Macaulay Duration (MD) and Credit Risk Value (CRV) are the two bases for categorizing debt funds. While Macaulay Duration (MD) determines the interest rate risk, Credit Risk Value (CRV) helps assess credit risk.

MD is the duration in which the investor would fully realize the price paid by him for the bonds held by the debt fund in the form of interest payments and principal repayments. MD is calculated in years, and a lower MD accounts for a lower interest rate risk.

So if there are multiple securities in a scheme, the weighted average MD of all the schemes is taken as the MD for the scheme.

MD Classification for Debt Funds

• Class I- MD of up to 1 year (potential interest rate risk is the lowest)
• Class II- MD of up to 3 years (potential interest rate risk is moderate)
• Class III-Any other MD (potential interest rate risk is the highest)

Determining credit risk for debt schemes is pretty straightforward; SEBI has assigned Credit Risk Value (CRV) to different debt securities. Credit risk shares an indirect relationship with CRV; the higher the CRV, the potential credit risk is lower, and the converse is also true.

For instance, Government securities are assigned a CRV of 13, while AAA-rated securities bear a CRV of 12, and unrated securities are given a CRV of 2.

CRV Classification of Debt Funds 

• Class A – Securities having CRV equal to or greater than 12 (lowest potential credit risk)
• Class B- Securities having CRV of 10 and 11 (moderate potential credit risk)
• Class C- Securities have CRV below 10. (highest potential credit risk)

Here's how a PRC matrix looks:

The Takeaway

Debt schemes are added to portfolios for hedging the overall risk as they are less riskier than equity investments. Prudent investors would not appreciate their hedge investments turning riskier than expected in the future and imposing additional risk on their portfolios. 

Due to the presence of interest rate risk and credit risks, the upper limit of the risk that an investor might have to bear could not be clearly identified. But with the PRC matrix, it's now possible to distinguish between debt funds bearing different degrees of risk and make informed investment decisions.

Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.