Mutual Funds

Why MF houses are assigning higher risk to liquid funds than longer duration categories

It’s a general perception that liquid funds carry the lowest level of credit and interest rate risk. However, various mutual fund houses have been placing liquid funds in the moderate risk category in the potential risk class (PRC) matrix even as they put longer duration funds in the low-risk category in the PRC. 

Markets regulator Securities and Exchange Board of India (Sebi) formulated the PRC on 7 June 2021, and the circular took effect from 1 December 2021. Mutual fund houses are required to display the PRC classification on their Scheme Information Document (SID), Key Information Memorandum (KIMs) and Common Application Form. This PRC classification exists in addition to the mutual fund riskometer.

Liquid funds invest in debt paper with a maturity of up to 91 days. This can include treasury bills (T-bills), tri-party repos, certificates of deposit (CDs) and commercial paper (CPs). 

The PRC has three risk categories for credit risk–A, B and C– and three risk categories for duration risk –I, II and III– all in the ascending order of risk. Mutual Funds are placed in one of the nine boxes taking both these factors into account. For example, AI is the lowest risk box and C III is the highest risk box. On 1 December, Sebi Mutual Fund released the PRC for its funds, putting SBI Liquid Fund into the B category even as it placed SBI Short Term Debt Fund in Class A. 

According to senior executives in the asset management industry, this is because the risk rating is assigned based on the long-term rating of the issuer and not the short-term rating. In other words, even if the short-term paper is rated as A1+ but the long-term paper of the same issuer is rated AA, the risk category is assigned as per the long term rating. 

Typically, liquid funds are comfortable with taking exposure to such issuers since the chances of default in the very short term are extremely low. “This is not a sign of excessive credit risk. It is just an outcome of the Sebi prescribed methodology,” one of the aforesaid executives clarified.

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