How do debt mutual funds manage exposure to hybrid securities?

Debt mutual funds manage exposure to hybrid securities by carefully assessing the credit risk, liquidity, and subordination of these instruments, while complying with SEBI regulations on investment limits and disclosures. Hybrid securities offer higher yields but come with added complexities, so fund managers use detailed risk analysis to ensure portfolio balance.

What Are Hybrid Securities in Debt Mutual Funds?

Hybrid securities are financial instruments that combine features of both debt and equity. In the context of debt mutual funds, common hybrid instruments include perpetual bonds (AT1 bonds), preference shares, and subordinated debt. These offer higher returns than regular bonds but carry more risk due to their equity-like characteristics.

How Do Fund Managers Evaluate These Securities?

Debt fund managers assess hybrid securities based on multiple factors:

• Credit quality: Fund managers look at the issuer’s creditworthiness and the security’s credit rating.
• Subordination risk: These securities are lower in the repayment hierarchy and may face losses before senior debt.
• Call and maturity structure: Hybrid instruments may have call options instead of fixed maturities, which can affect returns.
• Coupon deferral risk: In some hybrid instruments, the issuer can skip interest payments, adding uncertainty to income flow.

What Risk Management Measures Are Taken?

To manage risks from hybrid securities, debt mutual funds follow these practices:

• Exposure limits: SEBI limits the exposure of mutual funds to such instruments to reduce concentration risk.
• Stress testing: Fund managers perform regular tests to assess how these securities behave during market volatility.
• Diversification: Hybrid instruments usually form a small part of the overall portfolio to reduce impact.
• Disclosure: Fund houses must clearly disclose holdings of hybrid securities in their factsheets for transparency.

How Do Hybrid Securities Affect Fund Performance?

Because of their higher yields, hybrid securities can enhance a fund’s returns. However, during stress periods (like a credit crisis), these instruments can suffer sharp price declines due to low liquidity and skipped interest payments. Fund managers must strike a balance between generating extra returns and protecting the portfolio from unexpected shocks.

Hybrid securities add a layer of complexity to debt mutual fund portfolios. While they can boost income potential, they also increase credit, liquidity, and structure-related risks. Debt fund managers rely on stringent due diligence, regulatory limits, and risk modeling to manage such exposures prudently. Investors should always review fund holdings and risk disclosures before investing in schemes with hybrid exposure.