October 04, 2015

Rated AAAmfs

The recent downgrades of JPMorgan India Treasury Fund by CRISIL have left me wondering about the usefulness of its ratings for bond funds.  As CRISIL puts it, its rating of a scheme reflects “the likelihood of timely receipt of payments from the investments” made by it.  Schemes with a AAAmfs are considered to have “the highest degree of safety regarding timely receipt of payments from the investments that they have made”.  According to CRISIL, its ratings “serve as a tool to investors for selecting funds with a suitable risk-return criterion.”  These also provide “an independent opinion” on the credit risk associated with a fund’s portfolio.

All of this matches with my own expectations from a fund’s rating.  My issues begin when I look beyond the letter, and into the spirit of what a fund’s rating implies.  The core of my dilemma is this: when it comes to an individual bond, I recognize the possibility of a highly rated bond being significantly downgraded overnight.  But when it comes to a portfolio of bonds, I find it difficult to accept that there can be compelling reasons for a major downgrade overnight. In this post, I try to make my case.

Let me start by giving below the month-by-month share of lower rated securities (i.e. other than Sovereign/AAA/A1+) held by JPMI Treasury Fund:

 

AA+

AA

AA-

C

Unrated

Jan

7%

16%

3%

0%

6%

Feb

6%

10%

3%

0%

0%

Mar

5%

19%

13%

0%

0%

Apr

0%

13%

6%

0%

0%

May

0%

7%

12%

0%

0%

Jun

0%

7%

12%

0%

0%

Jul

0%

6%

10%

0%

0%

Aug

0%

3%

7%

6%

0%

JPMI Treasury Fund enjoyed a AAAmfs rating from before the start of the year, and this was reaffirmed in May.  It enjoyed this rating despite having around 37% of its March-end portfolio in securities rated lower than AAA.

Then, on September 1, CRISIL downgraded the fund to A+mfs (it subsequently dropped this to BBBmfs).  Going by its rating rationale for the September 1 downgrade, CRISIL did not have the latest portfolio composition at the time of taking that decision.  If, therefore, one had to go by the July portfolio and speculate what the August portfolio would have looked like (after the Amtek Auto downgrade), this is what my guess would have been:

 

AA+

AA

AA-

C

Unrated

Aug

0%

6%

5%

5%

0%

Frankly, I find it difficult to reconcile the rating profile of the securities in the fund with CRISIL’s rating of the fund.  CRISIL’s process may well be, as they claim, “derived scientifically”.  But to me, as an investor, there is a contradiction with my perception of what fund ratings imply, at least in spirit.  I expect a portfolio rating to warrant a major downgrade only if a large portion of the portfolio has been significantly downgraded or is likely to be so downgraded.

CRISIL explains the September 1 downgrade, saying that this was “on account of significant weakening in the credit risk profile of an underlying security.”   It goes on to say this: “Earlier, the scheme’s credit score had cushion to absorb some deterioration in the credit risk profile of the said underlying security. However, with the recent sharp weakening in the credit risk profile of the security, the credit score for the portfolio has been adversely impacted.”

I don’t dispute any of this.  But if the downgrade of a single security can cause such a significant downgrade in an entire portfolio’s rating, then it would seem to me that the risk of a concentrated holding in a single security was not factored in determining the rating.  In my view, it should have been a factor.  Put differently, if the downgrade of a single security can push the rating of a fund down by several notches, then I am not sure if a fund’s rating can be of much use to an investor.

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