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| Over the last two years, the Indian debt markets have seen high volatility because of the downward movement in interest rates and a compression in the spread between gilt's and corporate bonds of equivalent maturities. There were many interest rate cuts in the key international markets and in the local space.
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| In such markets, volatility of debt mutual funds becomes very critical to funds' performance. The funds with very high volatility or variability in returns are more prone to report capital erosion in unfavorable market conditions. Debt funds aim to provide regular income, by taking low risks, to the investors unlike equity funds, which promise to provide capital appreciation through aggressive investment strategies.
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| The performance of bond funds, among other factors, depends on the credit quality of the assets in portfolio and changes in market yields.
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| True, there are standard credit quality ratings, but these only indicate the quality of assets in the portfolio and do not capture the market risk. Interest rate movements in the market have an inverse relationship to the market value of the bond. No matter how good the asset is, if the interest rates rise, there will be depreciation in the value of the asset.
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| Empirical studies have shown that the fund management styles do not change frequently. More so because the fund manager is guided by the mandate given to him by the fund house as to how he will make the investments.
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| The bond fund volatility metrics uses this to find out how volatile the fund has been in the past and compares this with some fixed or absolute benchmark of pure market volatility. Standard deviation of the daily returns on fund net asset value as also the benchmark index is used for capturing the volatility of the fund and the benchmark indices.
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| The benchmark is usually a constant-maturity portfolio of government securities (which do not carry any credit risk). The volatility rating helps the investors to understand as to what level of market risk he is buying into. It also helps the asset management company to communicate the investment style of the scheme: aggressive or cautious in terms of market risk.
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| A fund with low to moderate volatility is expected to give low but more steady returns. However, a fund with very high volatility will give high returns when the going is good but also carries the risk of a sharp fall in returns in the face of adverse market situations.
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| Constant maturity benchmark indices have been used for comparing volatility within a group of funds. The concept of constant maturity benchmark portfolio is introduced to help the investor identify with the level of volatility he is willing to take in his investments. It is easy to interpret and communicate from the perspective of the fund house. Further, interpreting the volatility across time frames will be difficult without the constant maturity benchmark portfolios.
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| The use of government securities in the benchmark also takes away the credit risk since these securities do not carry any credit risk. The constituents of benchmark portfolios are changed regularly to ensure that it contains only liquid securities and that the selected securities represent all maturity buckets.
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| The volatility rating can be extended to other investment categories like gilts and money market schemes, too.
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| The rating expression in the volatility rating maps the volatility of the scheme's net asset value to the volatility of a representative portfolio composed of government securities. Thus, the rating conveys to the investor the level of volatility he is investing into.
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| Internationally, the credit quality rating is used in conjunction with the volatility rating in the case of bond funds in order to give a fuller sense of risk (credit risk + market risk) in a corporate debt portfolio. Typically, the credit quality and volatility ratings are written together like "AAAf / Vb2+".
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| As the fund market in India continues to develop and grow, the fund ratings are going to increasingly guide the investors in selecting schemes to invest in over and above the pure performance rankings. |
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