FundsIndia explains: Closed-ended hybrid debt funds

Last week we discussed about closed -ended debt funds and one of the most popular closed-ended debt fund category – fixed maturity plans (FMP). In this article, we’ll discuss the other closed-ended debt options.

FMPs invest their entire assets in debt instruments. Other closed-ended hybrid debt options such as capital-protection oriented schemes and dual advantage schemes invest most your money in debt instruments and some amount in equity. These debt-oriented closed-ended schemes are therefore different from FMPs. Let us understand what they are and how they work.

Capital protection-oriented schemes
Capital protection-oriented schemes (CPOs) seek to protect your capital. But they do not guarantee any protection. SEBI merely allows these funds to use the term ‘capital protection-oriented’ if they agree to follow certain requirements. These requirements could be about buying only credit rated instruments and ensuring the debt component grows to at least meet the principal amount. This way, whether the equity component delivers well or not, the investor’s capital can still be preserved.

Let us take an example for this. A 5-year closed-ended CPO plans to invest say 80% of its assets in debt and remaining in equity. So if you invest Rs 10,000, 80% or Rs 8000 will go into debt. Assuming the fund manages a 7% investment return on its debt component, post all the expenses it may incur (even assuming a maximum 2.5% expense ratio), the debt component would grow to over Rs10,000 in 5 years. The 20% in equity, whether it earns double-digit or single-digit returns would provide you with the capital appreciation. This is how CPOs are constructed. It is possible that the debt component itself delivers well in favourable debt markets.
Sometimes these schemes may also use derivatives, like a Nifty call option, to ensure that the equity portion is not volatile.
The other point to note is that the debt portfolio is constructed in such a way that it matures on or before the maturity of the scheme. Only then is it possible for the CPO to secure the returns it expects, to ensure that capital is preserved.
CPOs may come with different tenures such as 1,3, or 5 years or their maturity may be mentioned in days such as 1100 days, 1173 days and so on.

Dual advantage funds
Dual advantage funds are only a slight variant of capital-protection oriented funds. They do pretty much what CPOs do, except that they may have a higher component in equity, as they do not call themselves capital protection-oriented. They also do not have constraints on the nature of papers (in terms of risk profile) they can invest in, as opposed to limitations that a CPO may have. These funds too come with different maturities.

Interval funds
This class of funds also seek to invest fully in debt or a majority in debt and rest in equity. The key difference is that while the other funds we discussed mature after the said tenure, this class of funds open up (interval period) for investors to redeem their investments. If investors wish to continue their investments, they can be rolled over. Hence, the maturity of the underlying instruments will have to be before the interval or transaction period opens.

Apart from these classes of funds, there are hybrid debt-oriented closed-ended funds that come with different names – Multiple Yield Fund, Hybrid fund and so on.

Common features
• What is common between all these funds is that you cannot freely liquidate them nor invest in them other than during the specified transaction period (new fund offer period or interval period).
• Although they have to be compulsorily listed in the exchanges, their liquidity is poor. Also, many investors cannot go to the exchanges if they do not have a demat/brokerage account.
• As these funds are all either debt or debt-oriented funds, their taxation is like any other debt fund.
• In terms of performance, these funds, in the past, have not kept pace with open-ended actively managed medium and long-term debt funds in terms of performance. As their investing is mostly passive, and they are constrained by the product structure, they cannot take advantage of debt market dynamics and rate movements.
• Their returns also vary widely, based on their timeframe and their exposure to different debt papers. This category’s returns, in the past 1 year, for example, vary from 4% to 14%. This is because different funds lock-in to coupon rates. It is therefore not possible to enter a new fund looking at the performance of other existing funds as the coupon rates available for the new fund may be entirely different.
These funds are typically for investors who are looking for a FD-like product in terms of lock-in, limited volatility and getting a lumpsum sum after maturity. But even there, FMPs stand closer to FDs in terms of their risk profile, given that there is no equity component.

Also, for those wanting to build wealth with debt, a comparison with open-ended debt funds would be prudent, before making a choice. Open-ended funds have the flexibility to change their portfolio based on market scenarios. Also, your own freedom to change the fund (possible only in open-ended funds), if its performance is underwhelming, is a key feature you should keep in mind while choosing funds.

To read our earlier article on difference between open-ended and closed-ended funds click here.