What do we mean by "ratings upgrade cycle" and how can a fund make money from it? Rahul gives us a very useful primer on the concept, even as he explains how the portfolio of I Pru RIF is structured to make the most of this likely event. With a healthy portfolio YTM of 11.4% and potential gains from ratings upgrades that can mitigate re-investment risk, here's an accrual strategy product that should appeal to conservative investors who are looking nevertheless to preserve wealth net of taxes and inflation.

WF: Does your scheme mandate permit a small equity component like MIPs have or is this purely a debt fund?

Rahul: ICICI Prudential Regular Income Fund is a hybrid fund that aims to generate regular income through investments primarily in debt and money market instruments. The scheme does have a mandate to invest a portion of its corpus in equity instruments. However, equity investment is structured through arbitrage positions which the scheme will take when there are favourable arbitrage spreads available in the market.

WF: What frequency do you pay out dividends in this fund? How regular has the income distribution been in your RIF? What has been the quantum of dividend distribution in recent years?

Rahul: The fund has an option of monthly, quarterly and half-yearly dividends and has been paying out dividends to investors for these pay-out horizons. Over the last three years, the fund has maintained a reasonable average dividend yield of 5-6% per annum. However any dividend pay-out is subject to availability of distributable surplus with the Scheme/Plan/Option and approval from Trustees.

WF: With a modified duration of 1.29 years, one can argue that scope for capital appreciation is relatively muted. Will this be a fair observation?

Rahul: This fund is positioned for investors looking for relative stability in their portfolio. With higher duration and scope of capital appreciation comes higher volatility. Therefore, we manage this fund in a way to ensure lower participation to duration whereas higher participation to accrual income. We have other funds like ICICI Prudential Regular Savings Fund and ICICI Prudential Corporate Bond Fund in our Product Stable with potential to capture the capital appreciation from investing in duration.

WF: The current portfolio YTM of 11.14% is very healthy, but there is a reinvestment risk in a declining interest rate environment, especially for investors who wish to hold for 3 years to avail tax benefits. In what ways can portfolio returns stay ahead of markets in such a scenario?

Rahul: The fund's strategy is to seek better yielding investment grade papers to ensure relative stability of returns. To ensure this, it is important to keep sourcing good debt deals from the market. At ICICI Prudential Mutual Fund, we have a dedicated team that looks into directly sourcing debt deals from the market and this keeps us afloat in terms of the deal pipelines. We originate a significant portion of our credit investments on a direct basis where we engage with promoters or CFOs of the Companies. This enables us to save on arrangement fees thereby enhancing investor returns.

It is our constant endeavour to ensure that Yield to Maturity (YTM) fall less when compared to fall in market yields. This helps us maintain relatively better spread compared to market as far as YTM is concerned. In such cases the reinvestment risk could be lower and the fund would be able to generate reasonable accrual income even if interest rates fall.

WF: What is the key investment argument for your RIF and for whom is this a suitable investment solution?

Rahul: The fund is a short to medium term regular income solution for conservative investors looking for relative stability of returns and tax efficient alternative to traditional investment instruments. Following are the reasons why we believe there is a case for investing in this scheme now:

Accrual Income: The current portfolio YTM of 11.14% (as on May 31, 2015) offers better accruals. Considering the fact that interest rates are set to fall, it may be opportune time to lock investments at prevailing level of YTM.

Rating Upgrades: Credit profiles of corporates have been on an improvement path over last one year. The latest published Credit Ratio (upgrades to downgrades ratio) by CRISIL showed sustained upward trend by printing at 1.75 compared to 1.65 during H12015 and 0.9 during 2014. Improving macro indicators have led to surge in the upgrades over the last one year. Going forward improvement in private consumption, favourable commodity prices and mild upswing in domestic investments coupled with benign interest rate outlook can improve credit profile of corporates. This presents case for upgrades in credit ratings and thereby an opportunity to benefit from this credit upgrade cycle.

Upgrades in credit rating pull down yields and may lead to capital appreciation in the portfolio.

WF: How does a Mutual Fund scheme make gains from credit upgrades?

Rahul: A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. For example, if the 10-year G-Sec is trading at a yield of 6% and a 10-year AAA rated corporate bond is trading at a yield of 8%. In the above case the AAA rated corporate bond is said to offer a 200-basis-point spread over the G-Sec.

If yield falls the price of the bond increases, as bond prices are inversely correlated to bond yields. So in the below example if the A- rated bond was trading at Rs. 88 when its yield was 15.55% - It will now trade at Rs. 90 when the yield drop to 13.70%.

In case of a mutual fund scheme, the Fund manager identifies credit upgrade opportunities and once the instrument is upgraded there is a sell down opportunity as and when the target yield is achieved. The same amount is re-deployed in another upgrade opportunity or another credit structure with an aim to maintain the yield.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

The information contained herein is only for the reading/understanding of the registered Advisors/Distributors. All data/information in this material is specific to a time and may or may not be relevant in future post issuance of this material. . ICICI Prudential Asset Management Company Limited (the AMC) takes no responsibility of updating any data/information in this material from time to time. The AMC (including its affiliates), ICICI Prudential Mutual Fund (the Fund), ICICI Prudential Trust Limited (the Trust) and any of its officers, directors, personnel and employees, shall not liable for any loss, damage of any nature, including but not limited to direct, indirect, punitive, special, exemplary, consequential, as also any loss of profit in any way arising from the use of this material in any manner. Nothing contained in this document shall be construed to be an investment advise or an assurance of the benefits of investing in the any of the Schemes of the Fund. Recipient alone shall be fully responsible for any decision taken on the basis of this document

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