What you should know about the debt component in hybrid funds

Finance
 

In the past couple of years, debt funds have got a bit of a bad name because of the credit crisis. Although to be honest, most of the debt funds have managed to come out unscathed. But in all this mayhem, we seem to have forgotten that hybrid funds, too, have a fair share of debt instruments in them. Investors generally associate risk with the equity side of the hybrid funds’ portfolios. As a result, risks associated with the debt side are often ignored or not discussed. But the recent events in the debt fund space have thrown a spanner in the works. And it has disrupted the perception of debt component of hybrid funds being safe.

First of all, not all hybrid funds are alike. At a category level (as defined by SEBI a few years back), there are seven different types of hybrid fund types.

The 3 major ones are:

i. Conservative Hybrid Fund – Invests about 10-25% in Debt and 75-90% in Equity
ii. Balanced Hybrid Fund – Invests about 40-60% in Debt and 40-60% in Equityiii. Aggressive Hybrid Fund – Invests about 65-80% in Equity and 20-35% in Debt

There are few others, namely Dynamic Asset Allocation Funds, Arbitrage funds, Equity Savings Fund and Multi-Asset Allocation funds. But for discussion sake, let’s limit it to the 3 main categories only.

Since hybrid funds are allowed to have a debt component within their structures, the general perception is that hybrid funds are safer than pure equity funds. And due to their equity component, in the long run, they offer higher returns than pure debt funds.

Due to the varying allocation to equity and debt, the levels of risk also vary for all hybrid fund categories.

Now even the conservative hybrid funds that have 75-90% in debt are being questioned from credit and interest risk perspective. The market risk of the equity part of the portfolio has taken a backseat in people’s minds (even though it is still applicable as much as it was yesterday).

So let’s talk about these risks a bit more.

Some hybrid funds have been taking higher than necessary credit risk. They invest in lower-rated bonds/papers which offer higher yields. The idea is to generate a bit more returns from the debt part of the portfolio. But with higher returns in debt comes the many other risks. More so if the issuer’s business is impacted due to the pandemic and lockdown. So higher is the share of lower quality papers in debt portfolio of hybrid funds, higher are the risks of capital loss or NAV erosion due to write-downs if things take the not-so-good scenario route. Then there is another risk. The papers or bonds of longer duration are more sensitive to interest rate changes. So the hybrid funds that have higher components of longer maturity papers can see higher volatility in their NAVs.

Hybrid fund managers need to acknowledge one thing. And I am sure many know this already even though they don’t live by it. When an investor invests in hybrid funds, he / she wishes to generate slightly higher returns than pure debt plays. And for that, the equity component is built into the structure of hybrid funds (in varying degrees). But trying to generate higher returns by taking unnecessary risks on the debt side of the portfolio is plain wrong. It can backfire as has been seen in many adventurously managed debt funds lately.

So what should investors of hybrid funds do?

First is to understand that higher returns in hybrid funds should come from the equity side of the portfolio and not by taking undue risks in the debt side. Plain and simple.

So if you see a relatively high exposure to the below-top-rating debt papers in a hybrid fund, it’s a sure red flag. More so for the conservative hybrid funds category. The other aggressive hybrid fund category may still have limited exposure to such papers due to its aggressive mandate.

In general, hybrid fund investors need to be cautious about what kind of risks are being taken in the debt side of their schemes. Whether credit risk is high because a large share of investments is in below-than-highest-quality papers? And whether the fund manager is taking higher interest rate risk by holding papers of higher average maturity that are more sensitive to interest rate changes?

So if you are an existing investor or planning to invest in a hybrid fund, not only should you assess the equity side of the hybrid fund but also keep an eye on the debt side of the story. And even within the hybrid fund category, not all funds operate on similar lines. So choose the hybrid fund that matches your risk appetite and goal requirements by looking at both the equity and debt sides of the portfolio.

We haven’t even discussed the equity side of hybrid funds. But that is a discussion best left for another day, as the focus here is the debt side of hybrid schemes.

Written by Rakesh Sashmal