Risk/reward of long duration has mutual fund managers on the fence

50% of dynamic bond funds' average maturity at less than 5.5 years, the rest higher

With the Reserve Bank of India (RBI) placing the interest rate-hike cycle on pause, is it the right time to shift debt allocation to longer-duration papers?

Mutual fund (MF) managers are on the fence.

At the end of March, half the dynamic bond fund (DBF) schemes had an average maturity of less than 5.5 years. The rest had gone long on duration, with an average maturity of over 5.5 years.

DBFs are debt MF schemes similar in concept to flexi-cap funds in the equity space. DBF managers have the flexibility to switch allocations between shorter and longer maturity papers, depending on the interest rate cycle.

DBFs were maintaining an average maturity of about four years in September 2022. This rose to 5.4 years by November 2022 and has since remained in the same range.

Fund managers of schemes maintaining a shorter duration cite a flat yield curve and a favourable risk/reward proposition of short- to mid-duration to rationalise their standpoint.

“The duration in our fund has been in the range of 4-4.5 years. This is playing the part of the curve where we find the risk/reward being favourable while being overall constructive on duration,” says Dinesh Ahuja, fund manager, SBI DBF.

“Currently, we are more positive on the short duration end which, we believe, looks better than the longer end, as the yield curve is flat at this point. Given we are in mid-cycle, we do not see any significant benefit to investing in longer-duration assets. However, we may trade long duration tactically,” says Manish Banthia, deputy chief investment officer-fixed income, ICICI Prudential MF.

Fund managers who are constructive on longer duration are doing so on the prospects of earlier-than-expected rate cuts in the US and the RBI doing likewise, and a lesser probability of yields spiralling.

“The RBI has followed the US Federal Reserve (Fed). The Fed is concerned about the risks of a banking system crisis. This may lead the Fed to pause faster than anticipated. We expect a Fed cut, whenever, to be a precursor to an RBI cut,” reads a recent note from DSP MF.

“Positive global externalities should help ease the pressure on interest rates amidst volatility. The absolute yield levels remain attractive. With the outlook getting incrementally better, we have increased the duration of our scheme,” says Parijat Agrawal, head-fixed income, Union Asset Management Company.

Another factor making the case for investing in longer duration is expectations of muted supply, especially from states with a high cash balance.

Experts see the benchmark 10-year bond trading in the broad range of 7-7.4 per cent. The yields have remained in this range for over a year now.