1. Retail Research
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Impact of Credit Rating in debt instruments on MF returns
Mutual Fund Debt Category Analysis October 11, 2013
Impact of Credit Rating in debt instruments on Mutual Funds returns
Prologue: Contrary to the current unstable macro economic environment in the domestic front wherein the risk of
downgrading seems to be haunting the lower rated debt securities, the debt mutual funds that invest their
maximum assets in “AA & Below” rated securities outperformed the funds that have invested their maximum in
“AAA/A1” (highest rated) bonds.
While looking at the performance chart of income funds category that consist of 40 schemes, six out of ten in the
top quartile are from the schemes which are holding the maximum in the lower rated debt papers. On the other
hand, there are three schemes that allocate maximum to “AAA/A1” (highest rated) bonds.
Generally, the prices of the lower rated debt instruments fall the most during the periods wherein there is high
uncertainty over direction of interest rate movements in an economy in comparison to the highest rated debt
instruments. Consequently, the mutual fund schemes which have allocated most to these securities see
depreciation in their NAVs and end up with lower or negative returns.
The present situation in the domestic front seems to be reflecting the same as the credit quality of corporates in
India seems to be weakened by growth slowdown, high currency volatility and higher-than-expected interest rates
which may result in an increased likelihood of credit downgrades and defaults in the medium to low rated debt
instruments.
Contrary to the above view, schemes that have invested their maximum assets in “AA & Below” rated securities
outperformed the schemes that hold the maximum in highest rated papers.
In fact, the outperformance shown by the above mentioned schemes (the schemes investing mainly in lower rated
papers) was mainly attributed to the efficient call strategy taken by the fund managers on adopting accrual
strategy rather than rolling down the yield curve. Given the inverted yield curve scenario, low modified duration
coupled with minimal portfolio average maturity will result in achieving higher returns with lower risk. The
maximum exposure into such ‘A’ and ‘AA’ rated instruments also boosted the returns of the schemes as they
provide higher returns than the higher rated debt instruments.
Key findings: Debt mutual fund schemes that have invested maximum of assets in “AA & Below” rated debt
securities outperformed the schemes that hold maximum in AAA/A1 rated debt securities in the last two years
period.

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Impact of Credit Rating in debt instruments on MF returns
Mutual Fund Debt Category Analysis contd…
Performance of Income funds category: 1st
Quartile performers (i.e, top performers):
The above table portrays the list of schemes in the first Quartile performers (top 10 schemes in terms of point to
point returns out of 40 schemes) in the income funds category. There are six schemes that invest mainly in lower
rated papers as seen in the table while only three schemes seen placed in the table that allocate their maximum
assets in highest rated papers.
The table further shows the differentiation between present and historical performance by comparing the output
of point to point (trailing) and Rolling Returns. Only four schemes out of ten are seen placed in the first Quartile
based on the rolling returns (see the last column of the table) despite the fact that all the above listed schemes
are the top performers as per the point to point data. Hence looking at rolling returns data is more meaningful.
Further, in our earlier report, we have reiterated that the schemes that maintain lower modified duration close to
2 years could outperform in the near term. The same is proved in the above table, wherein six out of ten lower
modified duration schemes appear. We would think that this strategy could work going forward at least for next 4
to 6 months considering the high uncertainty seen in the interest rate arena.
Note: Trailing Returns up to 1 year are absolute and over 1 year are CAGR. NAV/index values are as on Oct 7, 2013. Rolling returns calculated on the last three years data.

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Impact of Credit Rating in debt instruments on MF returns
Mutual Fund Debt Category Analysis contd…
Portfolio characteristic of the Income funds category given the last one year period:
Most of the Debt mutual fund schemes in India allocate their asset mainly in highest quality ‘AAA’ or ‘A1’ papers.
However, some of the fund mangers prefer to invest in AA and A rated papers given their attractive yields.
Normally, lower rated debt securities bear higher coupon rates than that of the highest rated papers due to their
comparatively lower creditworthiness. However, fund managers normally do not compromise on the credit
worthiness of bond issuers hence the risk of default in mutual fund portfolio is very low. The credit research
carried out on every instrument prevents possibility of a default and the consequent loss in the debt portfolios.
It is worth noting to say that there is no active management or value add in a portfolio that contains only AAA
rated debt securities (except the timing of entry), wherein the inclusion of AA and A (not below these ratings)
enables fund managers to take more active calls (on creditworthiness and timing) which may result in achieving
higher returns with taking a bit higher risk. Further, fund managers bet on lower rated bonds from companies with
strong fundamentals with the intention that these papers may be upgraded in rating in the near future. This will
add up extra value on the portfolio. But on the flipside that could end up with loss also.
Considering the latest portfolio of the Income funds category (as of Aug 2013), close to Rs. 37,756 crore is held in
highest rated (AAA/A1) papers while Rs. 23,223 crore has been invested in AA & below rated papers. The allocation
into highest rated papers such as in “AAA/A1” saw fall in the last six months period (it was close to Rs. 50,000
crore in Mar 2013) as the fund managers prefers to bet on short term as well as long term government securities.
Overall rating break up in the income funds portfolio: Break up in the lower rated papers in the portfolio:

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Impact of Credit Rating in debt instruments on MF returns
Mutual Fund Debt Category Analysis contd…
Reduced % of holding in the lower rated papers (AA & Below) by the Income funds category:
% of Holding in 'AA & Below ' rated debt securities by Income funds
15
17
19
21
23
25
27
29
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
6
7
8
9
10 Yr G Sec Yields (RHS)
AA & Below' rated debt securities
The below chart shows the gradual decrease in the asset allocation into lower rated papers (AA & Below) by the
Income funds category in the last one year period. This is mainly due to the rising concerns over the risk of default
in the lower rated papers given the uncertainty over the economic growth in the domestic front.
According to the latest portfolio data (as of Aug 2013), there are nine schemes in the income funds category have
allocated more than 50% of their assets in the lower rated papers. Lower rated papers means investing in AA+, AA,
AA-, A+, A and A- rated debt instruments. None of the schemes have invested in below these papers like BBB and
below. The Aug 2013 portfolio data shows that the income category has invested close to Re. 10,065 crore, Rs.
3,877 crore and Rs. 5,272 crore respectively on AA+, AA and AA- rated papers. A sum of Rs. 3,757 crore is parked in
the debt securities that are rated A+, A and A-.
Templeton India Corporate Bond Opportunities, Pramerica Credit Opportunities and Templeton India Income
Opportunities are the three schemes in the category investing maximum assets in lower rated securities - 82%, 77%
and 72% respectively. In the last one year periods, Pramerica Credit Opportunities (23% to 77%), Escorts Income
(31% to 58%) and Birla SL Medium Term (39% to 65%) are the schemes that increased their holding in lower rated
papers considerably.
Investment in the lower rated instruments by the income funds portfolio:

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Impact of Credit Rating in debt instruments on MF returns
Mutual Fund Debt Category Analysis contd…
Schemes from the Income category that allocating their maximum assets in “AA & Below” rated securities:
Templeton India Corporate Bond Opportunities: Pramerica Credit Opportunities:
Birla Sun Life Medium Term:ICICI Pru Regular Savings:
Templeton India Income Opportunities: Reliance Regular Savings Fund-Debt:

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Impact of Credit Rating in debt instruments on MF returns
Mutual Fund Debt Category Analysis contd…
Long term debt papers that are downgraded by the rating agency in the last three months period:
The above table lists out some of the long term debt instruments (source: tickerplant.com) which are downgraded
by the rating agencies in the last three months period. Experts advise to stay away from the issuers that are
belonging to the sectors such as power, construction, engineering and steel as they are exposed to high default risk
at this current juncture.
Break up in Long & short term papers in Income funds Portfolio: Allocation into different Long term instruments by Income funds:
0%
20%
40%
60%
80%
100%
Aug-12
Oct-12
Dec-12
Feb-13
Apr-13
Jun-13
Aug-13
Lo ng T erm
instruments
Sho rt T erm
instruments
C ash & Equivalent
0%
20%
40%
60%
80%
100%
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
C o rpo rate D ebt &
P SU B o nds
Go vernment
Securities
P T C & Securitized
D ebt
F lo ating R ate

7. Retail Research
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Impact of Credit Rating in debt instruments on MF returns
Mutual Fund Debt Category Analysis contd…
Rating - FAQ:
What is credit rating?
A credit rating indicates the probability of a borrower repaying the debt or defaulting on debt payments. Debt payments include both the interest and the principal. A poor
rating indicates a high probability of default on debt payments.
A credit rating is assigned to either a debt security or a borrower by a credit rating agency. Globally there are three major rating agencies: Standards & Poor’s, Fitch and
Moody’s. In India, there are five ratings agencies: CRISIL, ICRA, India Ratings, Brickwork and CARE. Every rating agency has its own scale of credit ratings to indicate the
probability of default.
Government securities (or GILTS) have a sovereign rating (SOV), indicating absolutely no risk of default for the citizens of that country.
What does credit rating convey?
Credit rating is an assessment of the probability of default on payment of interest and principal on a debt instrument. It is not a recommendation to buy, sell or hold a debt
instrument. Rating only provides an additional input to the investor and the investor is required to make his own independent and objective analysis before arriving at an
investment decision.
How is credit rating done?
Ratings are based on a comprehensive evaluation of the strengths and weaknesses of the company fundamentals including financials along with an indepth study of the
industry as well as macro-economic, regulatory and political environment.
What do the various rating symbols mean?
Each rating symbol is an alphanumeric representation of the probability of degree of repayment risk associated with debt instruments.
Are rating symbols the same across all types of debt instruments?
No. Rating symbols may vary depending on the type of debt instrument, as for example long term or short term.
What do the “+” and “-”sign indicate in a rating?
Plus and minus symbols are used to indicate finer distinctions within a rating category. The minus symbol associated with ratings has no negative connotations. In fact,
ratings in a higher rating category such as ‘AA-‘ are stronger than ratings in a lower rating category such as ‘A+‘.
Who pays for the credit rating?
In India, the issuer company pays for the credit rating.
Who regulates rating agencies?
SEBI.
Is rating a one time exercise?
No. To protect the interest of investors, SEBI has mandated that every credit rating agency shall, during the lifetime of the securities rated by it, continuously monitor the
rating of such securities and carry out periodic reviews of all published ratings.

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Impact of Credit Rating in debt instruments on MF returns
Mutual Fund Debt Category Analysis contd…
Why do ratings change?
Rating is an opinion based on information available at a point in time with the rating agency and expectations made on the basis of such information by the agency.
However, information can change significantly over time causing the rated instruments performance to deviate from the earlier expectations thereby affecting the future
repayment abilities and thus, requiring the rating to be altered
What does a rating downgrade indicate?
Rating is monitored throughout the life of the instrument. A downgrade in the rating indicates that the risk of default of the instrument is higher than what was earlier
predicted.
What are the common factors that are taken into account while awarding the credit rating?
Each credit rating agency may have its own set of criteria and different weight age for each component for assigning the ratings. Some of the common factors that may be
taken into consideration for credit rating are Issuer Company’s operational efficiency, level of technological development, financials, competence and effectiveness of
management, past record of debt servicing, etc.
Long-Term Debt Ratings:
The long-term credit rating scale ranges from AAA to D. AAA indicates a low probability of default and D indicates that the borrower is in default, or will most likely
default.
An additional ‘+’ or ’–‘ sign is affixed to the ratings (AA to C) to indicate higher or lower quality among the debts of the same rating. For instance, a debt security rated AA+
has better quality than AA. A debt security rating of AA- is of lower quality than a rating of AA.
AAA is the best credit rating possible for a non-government debt security. This rating indicates that the borrower will repay the principal and the interest on time and has
adequate reserves to fulfill debt payments.
Ratings from AAA to BBB- are considered investment-grade ratings. Debt securities rated from AAA to BBB- are mostly purchased by mutual funds and institutional investors,
as they are safer than speculative debt securities.
Any rating below BBB- (i.e., BB+ and below) is considered speculative grade. These debt securities are for people who can take high risk as the risk of default is
considerably higher in comparison to investment-grade debt securities.
The returns are also considerably higher than investment-grade debt securities. Such speculative securities are more commonly known as high-yield securities. Globally,
there are special mutual funds called high-yield funds that invest into these speculative-grade securities. As of now, there are no high-yield mutual funds in India.
Any security with a ‘D’ credit rating will default or has already defaulted. These securities are for investors who are comfortable with very high risk. Most issuers of D-rated
debt instruments are sick companies in the process of financial reconstruction. If the issuer is able to recover financially, then the D-rated debt security holder gets returns
of high magnitudes.
Short-Term Debt Ratings:
The length of the scale is different for different ratings agencies. The rating scale ranges from 1 (highest quality) to 5 (lowest quality). The rating agency can use ‘+’ to
indicate better quality.
Investors are advised to invest in short-term bond funds with most debt securities with ratings of 1 and 2. Investors with higher risk appetites may invest in bond funds with
debt securities with ratings of 3 or more.

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Impact of Credit Rating in debt instruments on MF returns
Mutual Fund Debt Category Analysis contd…
Rating Scale: Long term debt instruments - instruments with original maturity exceeding one year:
Rating Scale: Short term debt instruments- instruments with original maturity of/upto one year:

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Impact of Credit Rating in debt instruments on MF returns
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Mutual Fund Debt Category Analysis
Analyst: Dhuraivel Gunasekaran. (Database sources: AMC Sites, NAVIndia and Ace MF)
HDFC Securities Limited, I Think Techno Campus, Bulding –B, ”Alpha”, Office Floor 8, Near Kanjurmarg Station,
Opp. Crompton Greaves, Kanjurmarg (East), Mumbai 400 042 Phone (022) 30753400 Fax: (022) 30753435
Disclaimer: Mutual Fund investments are subject to risk. Past performance is no guarantee for future performance. This document has been
prepared by HDFC Securities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or
copied or made available to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The
information contained herein is from sources believed reliable. We do not represent that it is accurate or complete and it should not be relied
upon as such. We may have from time to time positions or options on, and buy and sell securities referred to herein. We may from time to time
solicit from, or perform investment banking, or other services for, any company mentioned in this document. This report is intended for non-
Institutional Clients.
Investors with low risk appetite could look at investing in low modified duration schemes with highest rated
papers.
Investors who want to bear some risk could look at investing in low modified duration schemes with lower rated
papers (not below A-).
Investors who want to bear high risk could look at investing in medium to high modified duration schemes with a
mix of rated papers.
Investors who can catch the timing can also ride the up-gradation in ratings of corporates when the economy is on
the upswing.
Conclusion: