LDFs: Suitable for long-term investors with higher risk appetite

Long-duration funds (LDFs) delivered an average return of 11.4 per cent in the year ending November 27, 2024. New fund offers from Franklin India and Mirae Asset Long Duration Funds are currently open for subscription.

 

The yield of 10-year government securities (G-Sec) has eased over the past year from 7.1 per cent to 6.8 per cent. “Since yields/interest rates and bond prices move inversely, it has added to the mark-to-market (MTM) component of returns of long-duration funds. Being long-duration, a high ‘modified duration’ acts as a multiplier on yield movements, and has a high impact on price levels,” says Joydeep Sen, corporate trainer and author.

 

 

Accrual gains have been another driver of returns. “Alongside MTM gains, these funds also earned income from the interest accrued on their bond investments. This combination of steady interest income and capital gains has been a significant driver of these funds’ strong returns,” says Sirshendu Basu, head-products, Bandhan Asset Management Company (AMC).

 

Investment approach

 

LDFs primarily invest in high-quality bonds, often G-Secs. Some follow a roll-down strategy, holding bonds until maturity, while others actively manage duration based on interest rate view. “LDFs invest in debt and money market instruments with Macaulay duration of the portfolio greater than seven years. These funds aim to benefit from interest rate movements and typically offer higher yield potential, but with increased interest rate risk,” says Basu. 

 

 

As of October 31, 2024, LDFs managed assets worth Rs 19,341.7 crore, according to the Association of Mutual Funds in India (Amfi) data.

 

Benefiting from rate cuts

 

Falling interest rates drive capital gains for LDFs. “LDFs typically thrive in a falling interest rate environment. With the US Federal Reserve indicating a total of 200 basis points rate cuts by calendar year 2025 and expectations of the Reserve Bank of India (RBI) initiating rate reductions from February 2025, these funds are positioned for further growth,” says Abhishek Bisen, head-fixed income, Kotak Mahindra AMC.

 

“The forthcoming rate cut cycle could be a shallow one of 50-75 basis points. Part of the rally has already happened. It is a good time to invest in these schemes even now to gain from the remaining part of the rally,” says Sen.

 

Risks to consider

 

LDFs carry significant interest rate risks. Rapid rate increases could result in MTM losses. “Longer duration makes these funds more sensitive to interest rate fluctuations,” says Bisen.

 

Their mandate also makes them relatively inflexible. “The fund manager cannot reduce portfolio duration beyond a point, even when the view is bearish. Hence, these funds would underperform other debt fund categories in a bear market,” says Sen.

 

Only two funds in the category have a five-year track record.

 

Who should invest?

 

LDFs suit long-term investors. “They are ideal for investors with a horizon of three years or longer,” says Bisen.

 

Those seeking to benefit tactically from a rate-cutting cycle may also invest in them. “Allocation should, however, align with individual risk tolerance and investment goals,” says Bisen.

 

Investors need a longer horizon and a higher risk appetite to invest in these funds. “These funds’ volatility and return fluctuations could be relatively high due to geopolitical developments and domestic policy stances. Hence, investors with a long-term investment horizon and relatively higher interest rate risk appetite can invest in them,” says Basu.

 

These schemes can also complement Employees’ Provident Fund (EPF) or Public Provident Fund (PPF) investments for the fixed-income allocation in long-term portfolios.