Mutual Funds

Your Fund Portfolio

Dhuraivel Gunasekaran | Updated on March 22, 2020

Please explain the risk involved in short-, medium- and long-duration debt funds. How it will be affected by interest-rate changes? Is it advisable to invest lump sums in long-duration funds at this juncture or to start an SIP? Please also inform the return expectable for a period of one year.

K Ramachandran

Duration funds are debt mutual funds that benefit from capital appreciation by churning assets based on interest-rate movements. Post the re-categorisation of mutual funds in 2018, nine debt fund categories are classified as duration funds.

These are ultra-short duration, low-duration, short-duration, medium-duration, medium-to-long duration, long-duration, dynamic bond, gilt fund, and gilt fund with 10-year constant duration.

These funds are categorised based on Macaulay duration — the time an investor would take to get back all his invested money in the bond by way of periodic interest as well as principal repayments.

So, ultra-short duration funds manage the portfolio with a Macaulay duration of 3-6 months. Similarly, others are categorised as low-duration (6-12 months), short-duration (1-3 years), medium-duration (3-4 years), medium-to-long duration (4-7 years), long-duration (more than seven years) and dynamic bond (invest across durations). Gilt funds invest in government securities maturing in up to 40 years.

Debt mutual funds are exposed primarily to two risks — credit and interest-rate risks.

Credit risk arises when a debt fund invests in low-credit-quality debt securities which may default on repayment. Over the past 18-24 months, a spate of corporate bond downgrades and defaults have impacted the performance of several debt funds. Mutual funds that marked down their exposure to bonds issued by IL&FS, DHFL, Essel Group, Altico Capital India, Reliance ADAG, Adilink Infra & Multitrading, and Vodafone Idea, among others, have seen significant drops in their NAV.

Interest-rate movement in the economy plays an important role while managing duration funds. Fund managers of duration funds take a call on the direction of interest rate-movements and accordingly adjusts the duration of the portfolio to maximise returns.

Interest rates and bond prices have an inverse relationship. If interest rates move up, bond prices fall (as investors prefer newer bonds offering higher rates). So, if the fund manager forecasts interest rates to fall, she buys longer-dated bonds. If her calls go right, they benefit hugely. Else, they generate negative return.

A bond with a long maturity period is more sensitive to changes in interest rates than a bond with a short maturity.

Thus, investors must stay with funds with longer maturity when interest rates are expected to go down, and move to funds with short maturity when interest rates are either likely to stay stable or go up.

Hence, medium-to-long duration, long-duration, dynamic bond and gilt funds are more sensitive to changes in interest rates, resulting in high volatility in their NAVs. They are suitable for investors with a high risk profile and understand interest-rate movements very well.

Considering the present scenario in India, where the repo rate has been kept as low as 5.15 per cent and there is uncertainty over the direction of the interest-rate movement, it may not be a good idea to invest in long-duration funds at this juncture either in lump sums or through SIP.

Regarding your query on expected return for a one-year period, referring to the last one year’s return will not reflect the true picture of a fund’s performance. The best way to gauge the consistency of return is rolling return. Three-year rolling return calculated from the past five years’ NAV history shows that medium-to-long duration, long-duration, dynamic bond and gilt funds delivered a compounded annualised return of 8.1 per cent, 8.6 per cent, 8.6 per cent and 9.2 per cent, respectively.

Investors with a medium risk profile can consider debt funds that follow a blend of accrual strategy with short-duration play, such as banking and PSU debt funds and corporate bond funds.

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Published on March 22, 2020

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