Investors should beware of high volatility in long-duration funds

Long-duration funds are showing a category average return of 16.75 per cent over the past year, according to fund tracker Value Research. However, experts say that with bulk of the rally now behind, investors should be cautious on this category.
 
Long-duration funds, according to the Securities and Exchange Board of India’s (Sebi’s) definition, have an average duration of more than seven years. They tend to be highly sensitive to interest-rate changes. Over the past year, the yield on the 10-year government bond has fallen from 7.89 per cent to 6.57 per cent, a decline of 132 basis points. The Reserve Bank of India (RBI) has also cut the repo rate by 75 basis points in 2019, bringing it down to 5.75 per cent, its lowest level since 2010. “When interest rates fall, longer-duration funds enjoy bigger mark-to-market gains, which is why these funds are showing such high returns currently,” says Pankaj Pathak, fund manager-fixed income, Quantum Mutual Fund. (Medium- to long-duration funds and dynamic bond funds, with 1-year returns of 9.67 and 9.50 per cent, respectively, have gained from the decline in interest rates, though to a lesser extent.)
 
Experts say there is scope for further cuts of 25-50 basis points, and perhaps even more, depending on the RBI’s stance on growth. “Factors that may support a rate cut are the Fed changing its outlook to dovish, inflation being within the RBI’s comfort zone, continued open market operations by the RBI to ensure liquidity, and, most importantly, crude oil prices coming down from $80 to $64.5 a barrel,” says Saurav Basu, head-wealth management, Tata Capital Financial Services. Long-duration funds could benefit further from such a decline.
 

Nonetheless, investors should be cautious about taking a duration risk at this juncture. “A large part of the rally is behind us, and the markets are already pricing in another rate cut or two,” says Pathak. Interest rates have fallen in recent times due to decline in inflation, which in turn was driven by low food prices. “Food inflation is unlikely to sustain at the current low level. There is already a lot of distress within the rural economy because of low food prices. A sharp turn in food inflation could affect the performance of long-duration funds adversely,” says Pathak.
 
In the Budget, the government kept the fiscal deficit target at 3.3 per cent, but the assumptions underpinning this target are optimistic. It is factoring in tax revenue growth of 18 per cent at a time when the economy is slowing. The government may not be able to cut expenditure amid slowing growth. Hence, it could be forced to borrow more from the market. This would exert upward pressure on interest rates. Investors who wish to take a duration risk now should do so through dynamic bond funds rather than long-duration funds. In the former, fund managers have the flexibility to reduce the fund’s average duration if they believe that interest rates could rise. Long-duration funds, which do not enjoy this flexibility, could be hit hard by rising rates.
 
When selecting a debt fund category, investors should ensure that their horizon is at least equal to the duration of the category.
 
“Anyone who has a long-term goal and wants some debt exposure in his portfolio may invest in a long-term debt fund. But his goal should be at least three to five years away,” says Mumbai-based financial planner Arnav Pandya.
 
The bulk of the portfolio should be in shorter-term debt funds with a duration of less than three years. Since the credit environment is stressed, investors should ensure that the fund they select within a category does not have low-quality papers.