- Date : 11/07/2023
- Read: 4 mins
Debt duration funds involve investing in long-term debt funds for stable returns. On the other hand, a duration call is an investment strategy that makes quick gains through debt funds when the interest rates change. Let's understand the difference between the two.
- Long-term debt funds can be a suitable investment avenue if you expect interest rates to decline.
- Duration call is when you take a call on redeeming your debt duration funds, expecting an interest rate change in the future.
- Debt duration funds and duration calls are different from each other and must be understood when making investments.
The Reserve Bank of India (RBI) has steadily increased repo rates in recent quarters to curb inflation. As a result, the repo rate has climbed to 6.5%, causing repo rate-linked loans to become more expensive. However, rising rates have made deposits more attractive, prompting banks to increase their fixed deposit interest rates and the government to raise interest rates on small saving schemes.
When it comes to debt mutual funds, the impact of rising interest rates depends on the underlying duration of the fund. Long-term debt funds are more affected than short-term funds as interest rates rise. Existing long-term securities with lower rates become less attractive to investors, who prefer to invest in newly issued securities with higher rates. As a result, the portfolio value of long-term debt funds may decrease. Considering these factors, investors must develop a well-thought-out investment strategy to navigate the effects of rising interest rates.
The concept of duration debt mutual funds
Debt mutual funds can be classified based on the underlying duration of their portfolio. There are primarily four types of duration-oriented debt funds:
- Money market funds: duration of up to 1 year
- Short-duration debt fund: maturity of 1 year to 3 years
- Medium-duration debt fund: maturity of 5 to 6 years
- Long-duration debt fund: maturity of 10 years or more
Projecting changes in the repo rates
As the repo rates have been on a consistent rise in the recent past, experts have been predicting a possible reduction in the rates in the future. Although a specific timeline has yet to be established, many believe that the repo rates have reached their peak levels and can only fall from here on.
If this prediction comes true and the repo rates start to decline, it could lead to long-duration debt funds becoming more attractive as an investment option. These funds could offer better returns to the investors as the value of the securities in the fund's portfolio would appreciate with the decrease in the interest rates. Additionally, investors with a long-term investment horizon may benefit from these funds' potential gains and higher yields. However, it is important to note that investing in long-duration debt funds comes with its risks, and investors should evaluate their investment objectives and risk appetite before making any investment decisions.
What is a duration call?
A duration call is a strategy that differs from a duration debt fund. It is based on the belief that interest rates will decrease, and investors aim to profit quickly by exiting the fund when this happens.
However, this approach limits the potential for long-term investment in a long-duration debt fund. Duration calls prioritise short-term gains and are unsuitable for those seeking stable returns over a more extended period. Therefore, it is crucial to consider one's investment goals and time horizons before deciding on an investment strategy.
Things to keep in mind when making duration calls
If you invest in a long-duration fund by making a duration call, here are some things that you should keep in mind:
- Estimate the tentative repo rate cut that might happen based on your best guess.
- Determine the timeframe for when you expect the rate cut to occur. If it's more than a year away, a duration call may not be relevant in the current market.
- Consider the expected market movement after the rate cut. The return from 10-year gilt security is 7.2%, compared to a repo rate of 6.5%, creating a difference of 0.70%. Over the past two decades, the difference was around 1%. As the difference narrows, the market rally may be dampened due to the limited spread.
Understanding the difference between a debt duration fund and a duration call is essential, as they are two different investment strategies. The former involves investing in a fund with a specific duration, while the latter is a redemption strategy based on the belief that interest rates will fall.
As for predicting future rate cuts, it takes time to make an accurate forecast. However, estimating the tentative rate cut and horizon can help determine the relevance of a duration call in the current market.