Home / Money / Personal Finance /  Mind the debt portfolio’s risks when investing in hybrid funds

Investors in hybrid funds, which typically invest both in equity and debt classes, generally associate risk with the equity side of the funds’ portfolios and tend to ignore the risks associated with the debt side. But a recent event highlighted the fact that investors should be mindful of the risks the debt side of their hybrid funds’ portfolios carry. The net asset values (NAVs) of six hybrid fund-of-fund schemes of Franklin Templeton Mutual Fund registered a sharp decline in the range of 7% to 30% in a single day on 25 April. All these funds had exposure to six of the credit-oriented debt schemes which were shut by the fund house last month.

Typically, investors in hybrid funds are not risk-takers. “These are sold as safer products citing that the debt portion will take care of the volatility. Even hybrid conservative funds, which have higher debt exposure are sold as less risky," said Renu Maheshwari, chief executive officer and principal advisor at Finzscholarz Wealth Managers LLP. The products are sold with the promise that the majority investment is in debt instruments and the equity portion will take care of the inflationary aspect and help deliver returns superior to fixed deposits, said Maheshwari.

Therefore, investors are often not prepared for any volatility. We tell you how to evaluate the debt portfolio of a hybrid fund.

Varying levels of risk

At present, there are seven hybrid fund categories with varying exposure to equity and debt. The debt risk varies accordingly.

Funds in the hybrid conservative category have the highest exposure to debt as they can invest up to 90% of their assets in them. Funds in the hybrid aggressive and balanced categories can invest up to 35% and 60%, respectively.

In the dynamic asset allocation or balanced advantage category, the fund manager is free to invest 100% in either equity or debt, depending on the views on the markets. Right now, the average exposure of balanced advantage funds to debt instruments is 23%, as per their March-end portfolios, according to data provided by Value Research.

UTI Unit Linked Insurance Plan, a mutual fund that offers life insurance, has the highest debt exposure of 62%, while Motilal Oswal Dynamic fund has the lowest at 7%.

types of risks

Credit risk: Some of the hybrid funds, especially in the conservative category, are seen taking higher credit risk. Franklin’s hybrid funds are a case in point. The Franklin schemes it invested in were riskier because they took credit risk by investing in lower-rated papers, which generally offer higher yields than higher-rated papers of similar maturity. The risk of default or a rating downgrade is higher in these papers, so the risk of investors losing capital due to the fall in the NAV is higher too.

At present, Nippon India Hybrid Bond Fund has the highest exposure of 85% to lower-rated (AA and below) rated papers among all funds, as per its March-end portfolio. Three of Nippon India funds (Equity Hybrid, Hybrid Bond and Equity Savings Fund) in the hybrid category have weighted average yield-to-maturity (YTM) of 10-12%. YTM of a fund indicates how much return it is expected to deliver, assuming it holds all its debt papers till maturity. A higher YTM indicates higher returns, but it is also associated with higher risk, as the fund may be holding risky lower-rated papers offering higher yields. In a tough economic environment, there is a higher risk of such companies defaulting. “Currently, a YTM of above 9% should raise red flags," said Arun Kumar, head of research, FundsIndia.com.

Next in line is, ICICI Prudential Regular Savings Fund with an exposure of 52% to lower-rated papers. Franklin India Life Stage Fund of Funds 50s Plus, one of the six Franklin FoFs that saw a sharp decline in NAVs, in the hybrid conservative category, also had around 50% of its assets parked in lower-rated debt papers.

A majority of balanced advantage funds have almost nil allocation to lower-rated papers. “We have seen most balanced advantage or asset allocation funds not taking aggressive credit calls on the debt side," added Kumar.

Duration risk: This is the risk of the fall in the price of the bond in which the fund is invested due to rise in interest rates. When interest rates go up, bond prices fall, resulting in a fall in the fund’s NAV, and vise-versa. Longer duration bonds are more sensitive to interest rate changes and, hence, funds invested in longer maturity papers see higher volatility in the NAV.

However, experts believe duration risk can be managed by investing for the long term. “In case the duration call goes wrong, the risk of loss will be limited to fall in the mark-to-market price of the security. The investor can stay invested and hope for a recovery in the yields (when interest rates fall). But in case the credit call goes wrong, you are staring at a capital loss. The recovery may be really protruded or may never happen," said Santosh Joseph, founder and managing partner, Germinate Wealth Solutions.

Some funds avoid taking higher duration calls. “On the debt side, we invest in moderate duration papers with exposure to high-grade corporate bonds and government securities. Equities as an asset class is quite volatile. We don’t want to add undue risk of any form in hybrid funds. Hence, low to moderate duration debt strategy helps," said Lakshmi Iyer, chief investment officer (debt) and head of products, Kotak Mahindra Asset Management Co.

“In the fixed-income portfolio, the average maturity is limited to close to two years in our hybrid equity fund. We play duration tactically using government securities which are highly liquid. Our portfolio contains 80-85% in sovereign and AAA-rated papers. We do realize that the current environment is not conducive to taking credit calls," said Rajat Jain, CIO, Principal Mutual Fund.

What you should do

It is important to be cautious about the debt portfolio of your hybrid fund. “Investors should ask what kind of instruments the fund is investing in and is the fund taking duration calls or credit risk," said Joseph.

Also, look at the portfolio to see the allocation to lower-rated papers which increases the credit risk. “If a hybrid fund is taking credit calls, it may not provide the expected diversification as hybrid funds are supposed to follow a conservative approach," said Pankaj Pathak, fund manager, fixed income, Quantum Mutual Fund. A debt portfolio with higher average maturity is likely to be more sensitive to interest rate changes and can be more volatile than a fund that is holding shorter maturity debt papers.

Therefore, choose the fund which matches your risk appetite and look at both the equity and debt sides of the portfolio before investing.

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