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Managing credit risk: a one-on-one with Nimesh Shah

Nimesh Shah, MD & CEO of ICICI Prudential AMC, shares his views on what fund houses can do to better manage credit risks

Managing credit risk: a one-on-one with Nimesh Shah

ICICI Prudential has been less affected by the recent credit crisis that struck the mutual fund industry. What is it that you had done to strengthen your risk management in debt funds?
Prior to the launch of our credit-risk fund, we were conscious of the risks involved in managing such a fund. To address and mitigate such risks, we instituted an independent Investment Risk Management team which oversees the credit-evaluation and approval processes. We ensure that investments are made only after conducting appropriate credit due diligence and with requisite credit approvals. Credit due diligence includes both qualitative (management profile, industry outlook, competitive positioning, key risks and mitigation) and quantitative (financial and operating parameters) analysis.

We avoid concentration at individual-scheme level. We focus on client selection. The fact that none of our schemes have investments in papers issued by IL&FS group entities bears testimony to this. We have not solely relied upon external credit rating as the selection tool. We do not chase yield-to-maturity (YTM) as the sole metric indicating the potential future performance, especially in case of credit-risk funds.

Unlike duration funds (which generate returns through events resulting in interest-rate reduction), for accrual funds to generate return, two things are important: risk-adjusted rate of return and the time period of investments. Approaching each credit decision purely based on the internal due diligence and factoring in the liquidity risk has helped us. Credit investments have to be approached from a bottom-up perspective. There are good companies in bad sectors and bad companies in good sectors. Considering that the upside in any debt investment is capped, it may not be worthwhile to play contrarian.

Owing to all of these steps taken, ICICI Prudential has been able to deliver a positive investment experience for its investors.

Recent default and credit events have exposed a key chink in the armour of debt funds, which is that bonds often turn illiquid when they suffer downgrades. How can this problem be solved?
Just as volatility is an integral part of equity investments, rating upgrades and downgrades are part and parcel of credit investments. There is a need to differentiate between various rating downgrades. A downgrade in credit rating from AAA to AA has an entirely different connotation than that from BBB to BB. We need to appreciate that despite the downgrade, AA rated credit continues to belong to a relatively high safety grade.

While the asset (investment) side of mutual funds has been under scrutiny thanks to the recent events, what is important is to maintain granularity on the liability (AUM) side. For instance, in our Credit Risk Fund, we have a limit of Rs 100 crore stipulated on investments from a single investor. In many cases, conditions such as increase in coupon rate, trigger for acceleration of redemption, right to call for additional collateral are incorporated in the transaction documents to mitigate any adverse impact of ratings downgrade on the pricing of the paper.

The focus needs to be on ensuring adequate diversification, too. This ensures that even under the event wherein liquidity of a particular instrument gets adversely impacted, the overall scheme-level liquidity does not come under stress. Further, the schemes also needs to hold a mix of highly liquid securities, including cash (15 to 20 per cent of the scheme AUM), to cater to redemptions, if any.

There has been a lack of standard communication practices across AMCs on downgrades and defaults. What in your view is the best practice?
For any rating upgrade/downgrade, rating agencies usually issue a press release. The monthly factsheets published by AMCs also disclose the ratings of the individual papers across various schemes. We endeavour to communicate to our investors and distribution partners details outlining the credit event and its likely impact on our investments. Our strong processes in credit decision making and communication have helped to ensure a good investment experience for our investors.