What is the Potential Risk Class Matrix in Debt Mutual Funds? How Does It Work?

Debt mutual funds appeal to conservative investors who prioritise capital preservation over high returns. Though focused on stability, these funds are not devoid of risk.

They invest in interest-bearing securities such as government and corporate bonds, debentures, and treasury bills. Any changes in these instruments' interest rates can impact the debt funds' performance. So, how can you assess the risk associated with a debt fund?

This is where the Potential Risk Class (PRC) matrix comes in. It is designed to help investors better understand these risks. This article will explain the PRC matrix, how it works, and how to use it to your advantage.

What is the PRC matrix?

Since December 2021, SEBI has mandated that every debt mutual fund scheme must include a Potential Risk Class (PRC) matrix. This matrix sets limits on the maximum permissible risk levels for these schemes.

Debt mutual funds primarily face two types of risks: interest rate risk and credit risk.

Interest rate risk - This occurs when bond values decrease due to rising interest rates, leading to a decline in the scheme's Net Asset Value (NAV).

Credit risk - This arises if a company defaults on its debt obligations, causing bond values to drop and negatively impacting the scheme's NAV.

How does the PRC matrix work?

The PRC Matrix categories debt funds based on two main criteria:

1. Interest rate risk

It's assessed using Macaulay Duration and divided into three classes:

- Class I (low risk)

- Class II (moderate risk)

- Class III (highest interest rate risk)

2. Credit risk

It's evaluated based on the weighted credit risk of each instrument, determined by its credit rating. It’s categorised into three buckets:

- Class A (low risk)

- Class B (moderate risk)

- Class C (high credit risk)

Each fund is positioned in a specific cell within a 3x3 grid, indicating its levels of credit and interest rate risks. For example, a PRC classification of A-II signifies that the fund has low credit risk and a moderate level of interest rate risk.

How does the PRC matrix benefit investors?

Here’s how it can help investors:

• 1. Informed decisions
  This matrix links risk and potential returns, helping investors make smart choices based on their goals and how much risk they're comfortable with. For example, investors aiming for short-term goals might prefer funds with lower interest rate risk.
• 2. Comparing risk levels
  The PRC matrix makes it easy to compare the potential risks of different debt funds. Investors can find funds that match their risk preferences.
• 3. Matching risk preferences
  The matrix helps investors choose funds that fit their risk tolerance by grouping funds into clear risk categories. Those who prefer lower risk can choose A-I funds, while risk-tolerant investors may choose C-III funds.

In conclusion

The PRC matrix is a valuable tool for understanding and managing risks associated with debt mutual fund investments, allowing you to optimize your investment strategies effectively.