Longer-duration debt funds: Tactical bets are for high risk takers

Long-term investors who want near-certain returns may opt for a target maturity fund that invest in gilts

Debt fund categories that maintain high portfolio duration have performed well over the past year. Long-duration debt funds have given a category average return of 7.7 per cent. Gilt funds (whose duration can vary widely) earned 7 per cent while gilt funds with 10-year constant duration fetched 6.6 per cent. Given these returns, investors may be tempted to invest in them. They should first understand what they are getting into.

Good time to enter?

Experts say most major developed and emerging markets are at the end of their rate hike cycles. A couple of large central banks have or are on the verge of starting their rate-cut cycles.  

“Some uncertainty has been added in the past few weeks due to the uncertain global environment. So, we would advise investors to wait for a month or two before taking long-duration positions to avoid near term volatility,” says Pranay Sinha, senior fund manager-fixed income, Nippon India Mutual Fund.

Chance to reap capital gains

Over the long term, one can expect higher returns from these funds, compared to a shorter-duration fund as they invest in longer maturity bonds, which usually offer higher coupon rates. At present, with interest rates at or near peak levels, yield to maturity (YTMs) of these funds are on the higher side, so investors will get entry at a good level.

Investors could also take tactical bets on them. “If and when a rate cut cycle takes place, investors could reap the benefit of capital gains from their long-duration bond fund holdings,” says Sinha.

Adds Viplav Majumdar, founder, Planyourworld.com, “Retail investors should take expert help if they want to time their entry and exit.”

Volatile categories

Investors who bet on these funds should be prepared for volatility. When rates rise, their net asset values (NAVs) tend to fall sharply.

Moreover, there is uncertainty regarding rate cuts. “Just because the Reserve Bank of India (RBI) has paused does not mean that rates will necessarily fall from here. If inflation increases, the central bank could be forced to undertake hikes. If the US Federal Reserve keeps hiking rates, the RBI may be forced to follow suit,” says Deepesh Raghaw, a Securities and Exchange Board of India RIA (Registered Investment Advisor.

Interest rate cuts also appear to be some time away. In a recent poll conducted by Business Standard, seven of 10 participants said that they expect rate hikes to begin only from the first quarter of the 2024-25 financial year.

Who should invest?

Those keen to take a tactical bet and having the necessary risk appetite may go for these funds. Buy-and-hold investors may also go for them provided they have a horizon of 7-10 years and don't mind the interim volatility. “With a longer horizon, even if there is an adverse rate movement the capital loss gets recovered through coupon payments. There will also be rate cut cycles over a long period,” says Raghaw.

Who should avoid?

Majumdar says conservative investors who don’t want high volatility in their debt fund portfolios should avoid these funds.

Raghaw warns there could be times when their returns are negative over a year. He adds that investors who don’t understand their inherent volatility should avoid these funds. Those with very short horizons should also steer clear.

Precautions to exercise

Long-duration funds can invest in both corporate bonds and gilts. If you invest in a fund from this category, go for one that doesn’t take too much credit risk. “It is ideal to play long-duration strategies through sovereign or AAA bonds,” says Sinha.

Before investing in a gilt fund, understand how much interest-rate risk the fund manager takes.

The 10-year constant maturity gilt fund category must invest 80 per cent of its portfolio in gilt and also maintain a Macaulay duration of 10 years. This means it will always be highly sensitive to rate changes.

Majumdar suggests that buy-and-hold investors consider investing in a target maturity fund with a long maturity that invests in gilts. Such a fund would offer near-certainty of return if held till maturity.   

“With debt funds now taxed on a par with fixed deposits, compare a deposit’s return with a debt fund’s YTM to decide which is more attractive,” says Raghaw.