Long Duration Funds are offering Double-digit Returns. Should You Invest?

Long duration funds generated average returns of 11.3% and 15.8% in the last 1-2 years respectively, while Gilt funds with 10 year constant duration generated average returns of 11.7% and 15%. Besides, it was among the few categories of debt funds that did not witness outflows when the financial market turned volatile.

What is driving the superior returns?

The RBI has been cutting policy rates since 2019 to address growth concerns and infuse liquidity amid the standstill in the economy. Further, RBI has stated that their accommodative stance will continue as long as it is necessary to revive growth and mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target. Since 2019, RBI has cut policy rates cumulatively by 250 basis points. The repo rate now stands at a multi-year low of 4%.

Bond prices and interest rates are inversely related; so when interest rates fall, bond prices rise. Long term bonds are more sensitive to interest rate movement as compared to short term papers.

After RBI's two successive out-of-cycle policy rate cuts and proactive liquidity management, the new 2030, 5.77% 10-year G-Sec yield has softened significantly, boding well for bond prices.

When interest rates fall, older bonds yielding higher interest rate attract investors and the resultant demand moves up the prices, which results in higher NAV of the debt fund. This is why long duration fund have generated attractive returns amid rate cut.

Should you invest?

Long duration fund portfolio mainly comprises of government and quasi-government papers with minimal allocation to private issuers. From the credit risk point of view, these funds are relatively safer.

However, you need to be aware of the other risks involved. Long duration funds are prone to interest rate fluctuations.

During the falling interest rate scenario, these funds are likely to benefit; but if the rates start hardening the returns from these funds may become lower.

We are likely to be in the last leg of the interest rate cut cycle. The rates are likely to remain at the present level in the near term, but once the growth engine of the economy picks up, interest rate may start hardening. This would add to the volatility in long duration funds and the returns offered may come down.

Interest rate risk can be avoided only by timing the entry and exit, but then it is difficult to predict interest rate movement. Therefore, you would be better off if you avoid investing in long duration funds.

[Read:  Make Mindful Choices of Mutual Fund investments in Current times]

[Read also: Lessons Learnt from the Debt Fund Crisis]

Where should you invest?

You consider investing in Banking & PSU Debt Funds that are mandated to invest in a minimum 80% of its assets in debt instruments of banks, Public Sector Undertakings, and Public Financial Institutions.

Like long duration funds, portfolios of Banking and PSU Funds too mainly comprise of government and quasi-government securities along with some exposure to top names in the banking industry. These companies enjoy high-credit rating and government backing which makes it highly liquid and less prone to credit risk. Its performance track record has also been impressive.

However, one key difference is that Banking and PSU Funds invest in papers having shorter average maturity. The average maturity of long duration funds is around 10-12 years; the average maturity of Banking and PSU Funds is around 4 years. This means that Banking & PSU debt funds carry moderate interest rate risk.

Thus by investing in Banking and PSU debt funds, you can lower the interest rate risk and at the same time enjoy high credit quality.

If you wish to invest for the short term, consider investing in pure liquid fund and/or overnight fund that do not have high exposure to private issuers.

To select a scheme, essentially assess your financial objective, risk appetite, and investment time horizon, plus factors such as:

• The portfolio characteristics of the debt schemes

• The average maturity profile

• The corpus & expense ratio of the scheme

• The rolling returns

• The risk ratios

• The interest rate cycle

• The investment processes & systems at the fund house

At PersonalFN, we arrive at top rated funds using our SMART Score Model. If you wish to select worthy mutual fund schemes, I recommend subscribing to PersonalFN's unbiased premium research service, FundSelect.

Additionally, as a bonus, you get access to PersonalFN's popular debt mutual fund service, DebtSelect.

If you are serious about investing in a rewarding mutual fund scheme, Subscribe now!

Warm Regards,
Divya Grover
Research Analyst

Join Now: PersonalFN is now on Telegram. Join FREE Today to get ‘Daily Wealth Letter’ and Exclusive Updates on Mutual Funds