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AMC Speak
6 aspects to consider when evaluating a bond fund
Pankaj Sharma, EVP & Head of Business Development and Risk Management, DSP Blackrock
2nd February 2016
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In a nutshell
Pankaj shares six aspects that distributors must seek information on and independently assess, when evaluating bond funds to recommend to clients. Look beyond the portfolio - ask the AMC's sales team to share the investment thesis for all investments in AA- and lower rated papers.
Assess whether credit risk management is truly an independent activity in a fund house, not reporting into the fund management team. That's critical to minimize credit accidents.
Stress testing bond fund portfolios for liquidity risk and potential downgrade risk is part of prudent risk management. Ask fund houses to share outcomes of their own stress tests, to get a better understanding of portfolio risk.
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WF: What is the gist of the changes that SEBI has made in risk controls for debt funds? How will it impact portfolio construction and management - for the industry in general and DSP BlackRock in particular?
Pankaj: In a nutshell, SEBI has revised the single issuer and sector level exposure limits and introduced group level exposure limits for investments in debt instruments with an intention to mitigate risks arising on account of highly concentrated exposures in the wake of recent credit events. This is expected to be applicable to all fresh investments by funds. Though this would bring about a better diversification in the portfolios, it presents certain challenges with respect to portfolio construction. The reason being, our debt capital markets are dominated by issuances of financial sector entities, which cannot be easily replaced by corporate sector issuances having comparable liquidity and quality. The proposed changes may lead to reduced appetite from mutual funds for some issuers/groups, leading to increased funding costs.
WF: Blackrock, as the world's largest asset manager, has rich experience in managing credit in different environments. What are some of your global best practices in risk management that you have brought into your Indian operations, which go beyond domestic regulations?
Pankaj: BlackRock philosophy towards risk management guides us in our approach. Risk management is a core part of our organisation culture and is incorporated at the heart of the investment management process. We have an independent Risk & Quantitative Analysis (RQA) team with a clear mandate of risk oversight. Risk management is given due respect and relevance in the organisation hierarchy and we have a risk team that can effectively challenge the portfolio managers. At the Board level, the performance review and risk evaluation agenda is driven by the RQA team.
WF: Globally, regulators started subjecting banks to stress tests since the 2008 experience. Is there a case for stress test of bond fund portfolios, especially in the context of the ongoing commodity meltdown and its likely implications on commodity companies?
Pankaj: Asset managers have a fundamentally different business model than banks that use capital and deposits to finance their lending business - a business with leveraged balance sheet where regulator imposes capital requirements for credit, market, operations risks etc. Mutual fund is a fiduciary business with no leverage; the entire capital is provided by underlying investors. That being said, stress tests of debt fund portfolios, especially in the context of liquidity risk management and potential downgrade risk is prudent risk management.
WF: We keep hearing about an impending junk bond crisis in US and its potential impact on global markets. What exactly is the situation and why are concerns heightened on this front?
Pankaj: The Global Financial Crisis of 2008 led to co-ordinated monetary easing by central banks. Major markets had record low interest rates, which led to mispricing of risk as emerging sectors were able to access debt capital at lower rates. Investors were also eager to provide this capital as they were seeking higher income opportunities.
With the commodities market witnessing significant price depreciation, the financial metrics of companies in this area has deteriorated, leading to weakening of credit profile. The recent pickup in corporate bond defaults, especially in sectors such as energy, as well as closures by a few credit funds indicates investor concerns. Risk is getting repriced in the changing global macro environment, where investors are now challenging demand and growth assumptions.
WF: Domestically, credit risk management has become a key focus area after the Amtek Auto incident. What are the checks and balances that you maintain on your portfolios to guard against credit accidents?
Pankaj: At DSP BlackRock, we have always focussed on prudently managing credit risk. Credit analysis is an independent function performed by the RQA team, which sets up and monitors lending limits for debt issuers. Each credit proposal is analysed in depth by an independent Risk & Quantitative Analysis (RQA) team. The proposals are then discussed by an internal Credit Committee and a limit is assigned, if the issuer/structure is suitable. Regular monitoring of credits to track improvement/deterioration in credit profiles of issuers is done. In addition to credit risk, there is also a lot of focus on managing liquidity across the fixed income funds.
WF: Distributors are in a dilemma on how to evaluate bond fund portfolios for credit quality, ever since they found credit ratings dramatically change for a few companies, after the situations got out of hand. How would you advise distributors to satisfy themselves on portfolio quality, in this context?
Pankaj: In recent times, credit risk has come to the fore, as investors have experienced loss of capital due to credit events. The focus should be on the portfolio quality and not only historical returns. Distributors need to seek the relevant information when evaluating fixed income funds.
Seek investment thesis for each exposure which is rated below AA- Always look at Long Term Rating and Outlook Number of rating downgrades in the last 12 months Which companies have had their Outlook changed to Negative? What is the total fund exposure to such names? Single issuer and group exposure for each portfolio holding Total exposure to lower rated credits (AA- and below)
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