Rating criteria for capital-protection-oriented funds

Transcription

1 Rating criteria for capital-protection-oriented funds Executive Summary Capital-protection-oriented funds (CPFs) are funds where the structure of the scheme, with or without external support, ensures protection of the original investment at the scheme s maturity. As per the current regulations in India, capital protection has to be ensured by the scheme s portfolio characteristics; third-party protection is currently not permitted. CPFs offer opportunities to risk-averse investors to participate in upswings in the equity markets, while at the same time, protecting the value of the initial investment. The structure of CPFs and the performance of the debt and equity markets are factors that determine returns on investments in such funds. Securities and Exchange Board of India s (SEBI s) regulations require that CPFs be rated by a credit rating agency, with the ratings indicating the portfolio s ability to protect the capital invested. In this regard, CRISIL s ratings on CPFs provide an opinion on the degree of capital protection offered to investors. Scope: There are four structures used globally through which capital protection is ensured on maturity. The structures differ from each other based on the proportions of debt and equity. Trigger mechanisms built into the structures ensure capital protection on maturity. The four structures are: Static hedge Dynamic hedge Constant proportion portfolio insurance (CPPI) Dynamic portfolio insurance (DPI) Under static hedge, capital protection is provided solely through the debt portfolio. Put simply, even if the value of the entire equity portion of the portfolio is completely eroded, the cash flows realised on maturity of the CPF from the initial investment in debt securities will be at least equal to the fund s initially mobilised capital. This article explains CRISIL s rating methodology for assessing risks in CPFs that rely on the static hedge structure for ensuring capital protection. The other three structures are yet to be popular in India, given the greater complexities associated with these structures. This article outlines the following: Rating scale Methodology Surveillance process 1

2 Rating scale CRISIL s CPF ratings are an opinion on the likelihood of timely servicing of financial obligations and on credit risks in these instruments. It is not an opinion on the stability of the fund s NAV prior to maturity date. Since there is a structure (static hedge) which ensures capital protection, the ratings on CPFs are assigned on CRISIL s structured obligation (so) scale. Schemes with an original maturity of more than a year are assigned ratings on the long-term scale, while those with an original maturity of less than a year are assigned ratings on the short-term scale. Methodology CPFs are regulated by SEBI, the regulator for mutual funds in India. SEBI, in its guidelines for CPFs, defines a capitalprotection-oriented scheme as a mutual fund scheme which is designated as such, and which endeavours to protect the capital invested therein through suitable orientation of its portfolio structure. SEBI stipulates that CPFs launched be close-ended, and that AMCs should not repurchase units before the end of the maturity period. In India, capital protection for a scheme has to be ensured by the scheme s portfolio characteristics; third-party protection is currently not permitted. In static hedge structures, the debt component of each fund is sized in such a way that the cash flows from the debt investments at the time of redemption of the scheme will be equal to, or greater than, the fund s initially mobilised capital. In sizing the debt component, CRISIL factors in the default risk of debt securities, reinvestment risk of interim cash flows from debt instruments, tenor risk arising from unavailability of eligible debt securities whose tenors exactly match that of the fund, and the recurring expenses charged to the scheme. The remainder (the difference between the capital mobilised and minimum debt component) may be invested in equities, including futures and options; investors can, therefore, benefit from any appreciation in the equity portfolio value. At the same time, if equity markets decline, the portfolio structure is expected to protect investors from loss of capital on maturity. As an illustration, Table 1 depicts the various scenarios for an initial investment of Rs., of which Rs.90 is invested in debt securities while the remainder is invested in equities. On maturity, the debt securities are assumed to provide an outflow of Rs. equal to the initial investment. Table 1: Returns of static hedge under various scenarios Initial Investment 10 % 0 % -50 % Debt 90 Equity Total *ROE Return on equity investments 2

3 The key risks that CRISIL considers in analysing CPFs are the following: Credit risk: Each CPF will invest a certain quantum of the initial capital mobilised in debt securities. Therefore, this investment is exposed to default risk on these securities in the portfolio - the risk of repayments on these instruments not being made. CRISIL assesses this risk by analysing the credit quality of each debt security that the scheme invests in separately, and then aggregating the same through the credit quality rating methodology it uses for debt fund schemes. Currently, SEBI regulations restrict CPFs from investing in debt instruments rated lower than 'AAA'- which indicates highest degree of safety. Therefore, most AMCs invest in fixed-income securities of highest credit quality (or Government of India securities), thus ensuring that the credit risk of the debt securities is commensurate with the rating assigned for the scheme. If, however, the credit rating of a fixed-income security gets downgraded during the tenure of the scheme, the AMC shall ensure that the credit quality of the fixed-income portfolio is equivalent to 'CRISIL AAAmfs', in line with its credit quality rating methodology. If not, the AMC can rejig its portfolio to ensure that the credit quality rating of the fixed-income portfolio is consistent with the rating on the scheme. If otherwise, CRISIL will analyse the protection available from the debt and equity holdings of the scheme at that time, to decide whether the rating of 'CRISIL AAA(so)' on the capital-protected fund can be maintained. Reinvestment risk: Reinvestment risk on a portfolio arises when the cash flow received from the debt securities may not be deployed at the same yield received at the time of the initial investment. The scheme could face reinvestment risks on interim interest cash flows, if the yield on reinvesting these cash flows is lower than the yield on the initial investments. For instance, if the debt security has an annual coupon payment of 8 per cent, it may not be possible to invest the cash flow at a yield of 8 per cent, resulting in a shortfall in the final value of the debt portfolio. Therefore, a cushion for reinvestment risk needs to be built in to the computation of the minimum debt required to ensure capital protection on maturity Chart 1: Depiction of Reinvestment risk and float risk Float Risk Coupon payment Float risk Funds Received Investment in debt securities Maturity of Debt securities Fund Maturity t 0 t 1 t 2 t 3 t 4 t 5 Reinvestment risk Float risk: The structure may have a lower yield than projected if there are delays in funds deployment, or if the debt instruments are not co-terminus with the scheme's maturity. Hence, a cushion needs to build for float risk, at the start and maturity of the fund as well as float during rebalancing. This risk of float is factored by CRISIL while evaluating the minimum debt component in the initial investment mix, as Chart 1 indicates. 3

4 While evaluating the debt component in the initial investment mix, the reinvestment risk as well as the float risk is assessed by factoring in very low rates of interest for the interim cash flows. Warranties In addition to the above criteria, the scheme's fund manager has to comply with a standard set of warranties. The asset AMC furnishes a set of warranties to CRISIL. These warranties primarily pertain to the investment mix to be maintained to ensure capital protection on maturity, minimum quality of assets maintained by the funds, maximum tenure of investments in the portfolio, and the sharing of documents with CRISIL in order to ensure timely rating action. The warranties furnished by the AMC also include a commitment to invest the debt component of the funds only in Government of India securities and securities rated 'AAA' by CRISIL, or their equivalent. Warranties furnished by the AMC to CRISIL include the following: The AMC shall maintain an initial investment mix of equity and fixed-income securities such that the maturity value of the fixed-income portfolio, at the time of scheme's redemption, net of all expenses, is more than or equal to the face value of the units issued. The AMC shall submit to CRISIL, every month, portfolio details of investment in securities held by the fund. To the extent possible, the fund will not churn the debt securities in the portfolio. The AMC shall seek CRISIL's credit opinion a continuous basis on instruments not rated by CRISIL. The AMC shall ensure that the aggregate residual value of: o the outstanding position in cash-market segment; o premium paid or payable on option contracts; and o the notional value of exposures in the future segment shall, at any given point in time, not exceed the maximum permissible value of the non-debt portion. Further, the AMC shall not write or sell options during the entire tenor of the instrument. Surveillance Process for CRISIL's rating Once a CPF is rated, CRISIL places the fund under continuous surveillance. This means that CRISIL will review the fund's holdings on a monthly basis and may reevaluate the rating based on new information, whenever such action is warranted. Based on information obtained from the AMCs, it analyses the credit quality of the debt securities. Further, CRISIL also evaluates the possibility of cash flows from the debt securities (including cash flows from reinvestment of interim coupons) on the scheme's maturity falling below the initial capital mobilised. CRISIL will publish any change in rating, along with a rationale for the rating action. 4

5 Analytical Contacts Somasekhar Vemuri Head- Criteria and Product Development Tel: Chetan Rao Senior Manger- Criteria and Product Development Tel: About CRISIL Limited CRISIL is a global analytical company providing ratings, research, and risk and policy advisory services. We are India's leading ratings agency. We are also the foremost provider of high-end research to the world's largest banks and leading corporations. About CRISIL Ratings CRISIL is India's first, largest, and most prominent credit rating agency. CRISIL pioneered the concept of credit rating in India more than 20 years ago, and has played a pivotal role in the development of India's debt market. Today, CRISIL rates two-thirds of corporate bonds outstanding in India. As of 30 June 2011, CRISIL has rated more than 11,011 borrowers, covering around 34,342 debt instruments of a value exceeding Rs. 38 trillion. CRISIL has also assigned more than 20,000 Small and Medium Enterprise (SME) Ratings, and has the highest number of SME ratings outstanding in India. CRISIL Privacy Notice CRISIL respects your privacy. We use your contact information, such as your name, address, and id, to fulfill your request and service your account and to provide you with additional information from CRISIL and other parts of The McGraw-Hill Companies, Inc. you may find of interest. For further information, or to let us know your preferences with respect to receiving marketing materials, please visit You can view McGraw-Hill's Customer Privacy Policy at Last updated: 31 March, Disclaimer CRISIL has taken due care and caution in preparing this report. Information has been obtained by CRISIL from sources, which it considers reliable. However, CRISIL does not guarantee the accuracy, adequacy, or ompleteness of any information and is not responsible for any errors in transmission and especially states that it has no financial liability whatsoever to the subscribers/ users / transmitters / distributors of this report. No part of this report may be reproduced in any forms or any means without permission of the publisher. Contents may be used by news media with due credit to CRISIL. CRISIL. All Rights Reserved. CRISIL Limited: CRISIL House, Central Avenue, Hiranandani Business Park, Powai, Mumbai India Phone : Fax :