At a time when equity funds are generating abysmally low returns and interest on bank deposits and small savings schemes are on a downward trend, one category of debt fund has rewarded investors with double-digit returns in the last couple of years.

Long duration debt funds (including Gilt funds with 10-year constant duration) have outperformed other categories of debt funds in returns when many categories of debt funds have been generating lower returns. Notably, FPIs turned net sellers in the Indian debt market amid the uncertainty and risk aversion due to COVID-19 pandemic, which affected the performance of debt funds.

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.

Table 1: Long duration funds offered stellar returns in the last couple of years

Scheme Name CAGR (%) Absolute (%)
6 Months 1 Year 2 Years 3 Years 5 Years
Gilt Fund with 10 year constant duration
IDFC G-Sec-Constant Maturity Plan 9.12 13.04 16.88 12.60 11.58
ICICI Pru Constant Maturity Gilt Fund 9.40 12.57 15.46 10.64 11.20
SBI Magnum Constant Maturity Fund 7.76 10.94 13.90 11.10 11.10
DSP 10Y G-Sec Fund 8.61 10.39 13.58 8.13 9.81
Category Average 8.72 11.73 14.95 10.62 10.92
Long Duration Fund
Nippon India Nivesh Lakshya Fund 10.76 11.84 17.45 NA NA
ICICI Pru Long Term Bond Fund 7.87 10.85 14.05 9.38 10.77
Category Average 9.32 11.34 15.75 9.38 10.77

Data as on August 03, 2020
(Source: ACE MF, PersonalFN Research)

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.

Table 2: Series of policy rate cuts in 2019-20 to address growth concerns

Month Repo Policy Rate Policy rate cut  (Basis points) Monetary Policy Stance
19-Feb 6.25% 25 Neutral
19-Apr 6.00% 25 Neutral
19-Jun 5.75% 25 Accommodative
19-Aug 5.40% 35 Accommodative
19-Oct 5.15% 25 Accommodative
19-Dec 5.15% Status quo Accommodative
20-Feb 5.15% Status quo Accommodative
Mar-20 (an exceptional off cycle meeting) 4.40% 75 Accommodative
May-20 (an exceptional 2nd off cycle meeting) 4.00% 40 Accommodative
Total 250

(Source: RBI)

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

This article first appeared on PersonalFN here

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