{"id":20169,"date":"2020-12-30T11:09:50","date_gmt":"2020-12-30T05:39:50","guid":{"rendered":"https:\/\/www.fundsindia.com\/blog\/?p=20169"},"modified":"2020-12-30T16:24:04","modified_gmt":"2020-12-30T10:54:04","slug":"conservative-hybrid-funds-not-so-conservative","status":"publish","type":"post","link":"https:\/\/www.fundsindia.com\/blog\/mf-research\/conservative-hybrid-funds-not-so-conservative\/20169","title":{"rendered":"Conservative Hybrid Funds – Not So Conservative!"},"content":{"rendered":"

At the current juncture, fixed income investors need to be prepared for relatively lower returns both from Bank Fixed Deposits and Debt funds compared to the returns they enjoyed in the last few years. You can read the detailed rationale behind our view <\/span>here<\/span><\/a>.\u00a0<\/span><\/p>\n

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To put that in context, as seen above, the average yield to maturity (which roughly translates to the aggregate of interest rates paid by underlying companies of the debt fund) of our select debt funds from being above 8% a few years back has reduced to around 5% levels today.<\/span><\/p>\n

Given the low yields in both Bank FDs and Debt funds, there is an inherent temptation to shift to slightly riskier ‘Debt-Oriented-Hybrid’ options (with some equity exposure) for improving returns.<\/span><\/p>\n

Under this context of wanting to improve fixed income returns, one particular \u2018Debt-Oriented-Hybrid\u2019 category that is starting to get attention is the <\/span>Conservative Hybrid <\/b>category of funds. <\/b>These funds invest around 75% to 90% of their portfolio in debt instruments and the remaining in equities (i.e. 10% to 25% in equities).<\/span><\/p>\n\"\"<\/a>\n

The simple attempt is to improve returns via some exposure to equity.<\/span><\/p>\n

Sounds like a reasonable choice, right?<\/b><\/p>\n

But we have a slightly different view and would suggest you to be cautious while approaching this category.<\/span><\/p>\n

Why do we find conservative hybrid funds to be not so conservative?<\/b><\/span><\/h4>\n

Stating the obvious, the equity portion of the conservative hybrid funds carries market risk and naturally, the overall returns may be more volatile than a plain vanilla debt fund.\u00a0<\/span><\/p>\n

This is perfectly fine with us as any investor who chooses this category for improving returns knows upfront about the 10-25% equity exposure and the volatility that it brings along with it.<\/span><\/p>\n

Our real concern actually comes from four different sources:<\/span><\/p>\n

    \n
  1. Credit Quality of the debt portion<\/span><\/li>\n
  2. Higher Duration leading to interest rate risk in the debt portion<\/span><\/li>\n
  3. High Expense Ratios<\/span><\/li>\n
  4. Debt Taxation for the Equity portion<\/span><\/li>\n<\/ol>\n

    <\/h4>\n

    Concern 1: Most Conservative Hybrid Funds take some degree of credit risk to improve returns<\/b><\/span><\/h5>\n

    When we analyzed the debt portion (which amounts to more than three-fourth of the portfolio) of conservative hybrid funds, we found that most of the funds were taking credit risk to improve returns.<\/span><\/p>\n

    But hang on… what is credit risk?<\/b><\/p>\n

    There are certain debt funds which lend your money to lower rated corporates in return for higher yields (read as the interest rate paid by corporates for borrowing money from the fund i.e. indirectly from you).<\/span><\/p>\n

    As long as the underlying corporates fully service and repay their debts on time, these funds enjoy higher returns compared to higher credit quality debt funds (who lend predominantly to AAA rated corporates, financial institutions and government).<\/span><\/p>\n

    We have been avoiding such credit risk oriented funds, given the uncertain economic backdrop and the risk of redemption pressure (investors selling out of the fund).<\/span><\/p>\n

    As lower rated papers cannot be sold easily given the illiquid market for these securities, whenever there is a surge in redemptions from these funds, the fund manager is forced to sell other higher quality papers (which can be sold easily) in the portfolio. This usually leads to unintended higher concentration of lower quality papers in the fund significantly increasing the default and liquidity risks. The closure of 6 credit risk oriented funds of Franklin Templeton a few months back is a reminder of how liquidity risk can play out in the worst case scenario.<\/span><\/p>\n

    In our view, this makes credit risk oriented strategies extremely risky at this juncture.<\/span><\/p>\n

    Oops.. So what?<\/b><\/p>\n

    Conservative hybrid funds unfortunately invest a significant portion of their portfolio in the assets issued by lower rated borrowers in search for higher returns.\u00a0 Thus, this category tends to have higher credit risk and along with it the liquidity risk that follows.<\/span><\/p>\n

    The conservative hybrid fund category (top 10 funds by AUM) holds an average exposure of around 23% in instruments with credit rating lower than AAA.<\/span><\/p>\n\"\"<\/a>\n

    Over the past 5 years, the category has had consistently high exposure to non-AAA instruments at an average of 22% of the portfolio.<\/span><\/p>\n\"\"<\/a>\n

    While this is not to say that all non-AAA exposures are risky and may default, this is a risk that you must be aware of. Most importantly liquidity risk (read as sudden redemptions) is our biggest concern when it comes to funds taking exposure to lower rated papers.<\/span><\/p>\n

    <\/h4>\n
    Concern 2: Several Conservative Hybrid Funds take higher duration in portfolios implying higher degree of downside if interest rates move up<\/b><\/span><\/h5>\n

    In addition to credit risk, some of the conservative hybrid funds also tend to take <\/span>interest rate risk<\/b>.\u00a0 This risk arises due to the change in interest rates – increase in interest rates leads to price decline for the debt portion.<\/span><\/p>\n

    But hang on\u2026 What is Interest Rate Risk?<\/b><\/p>\n

    Let us explain this with a simple example.<\/span><\/p>\n

    Assume you have opened a Fixed Deposit for Rs 1 lakh at 6%, this will give you Rs 1,06,000 after 1 year.\u00a0 What if suddenly the bank increases its interest rate from 6% to 7% the next day?<\/span><\/p>\n

    This means, you got unlucky as you could have invested a lower amount – Rs 99,065 (vs the original Rs 1 lakh) to get the same 1,06,000 after a year.<\/span><\/p>\n

    What if instead, the bank reduces its interest rate from 6% to 5%?<\/span><\/p>\n

    In this case you got lucky as otherwise you should have invested more i.e. Rs 1,00,952 (vs the original 1 lakh) to get the same 1,06,000 after a year!<\/span><\/p>\n

    In the real world, FDs are not tradable. But hypothetically if you assume you could trade your FDs everyday, this implies the price of your FD will change if interest rates move up or down.<\/span><\/p>\n

    As seen above, if they move up, then your FD (already locked at lower interest rates) becomes less valuable and hence the trading price of your FD would come down to adjust for the new higher interest rates. Similarly, if interest rates move down, then your FD (already locked at higher interest rates) becomes more valuable and hence the trading price of your FD would go up to adjust for the lower interest rates.<\/span><\/p>\n

    This is exactly what happens in a debt fund which invests in bonds which are traded every day and the price of the underlying bonds fluctuates everyday based on change in bond yields.<\/span><\/p>\n

    If interest rates move up then your debt fund NAVs have a negative return impact and vice versa. However the extent of the same interest rate movement in your debt fund NAVs will depend on a parameter called modified duration.<\/span><\/p>\n

    Modified duration is measured in years and tells us what would be the expected increase or decrease in fund NAV for a 1% change in interest rates.<\/span><\/p>\n

    Change in fund NAV = (-1) * change in interest rates * modified duration<\/span><\/p>\n

    Assuming that a fund\u2019s modified duration is 4 years and the yields rise by 0.5% then the fund\u2019s NAV should drop by 2% (calculated with the above formula: (-1) * 0.5% * 4.<\/span><\/p>\n

    So higher the modified duration for a fund, higher the interest rate sensitivity.<\/span><\/p>\n

    Oops.. So what?<\/b><\/p>\n

    Modified Duration is on the higher side (> 3 years) for most funds in the conservative hybrid category with the average hovering around 3.6 years.<\/span><\/p>\n\"\"<\/a>\n

    Even in the past 5 years, most of the funds in the category have run modified duration more than 3 years.<\/span><\/p>\n\"\"<\/a>\n

    So overall when it comes to the debt portion most funds in this category have both<\/b><\/p>\n