- Date : 08/03/2023
- Read: 5 mins
Long-term financial goals like child education planning and own retirement planning require a diversified investment portfolio with equity, debt, gold, etc. Should you include long-duration funds in your debt portfolio? We explore what are these funds, the risks involved, and their performance.
In February 2023, the RBI hiked the repo rate to 6.50%. Many experts feel that we may be near the end of the interest rate hike cycle with a probability of 1-2 more rate hikes of 25 basis points in 2023. After that, the RBI may take a long pause and then start cutting interest rates once inflation is under control. Given this scenario, in this article, we will understand what long-duration debt mutual funds are, how they work, the risks involved, their returns, and whether you should invest in them.
What is a long-duration debt mutual fund?
A long-duration debt fund is an open-ended mutual fund scheme that invests in fixed-income instruments, such that the portfolio Macaulay duration is greater than 7 years. In simple terms, the Macaulay duration refers to the time (years) it will take the investor to recover their money invested in a fixed-income instrument (bond) through coupons (regular interest payments) and the principal repayment. As per SEBI guidelines, the Macaulay duration of a long-duration fund portfolio should always be more than 7 years.
a) Interest
Currently (as of February 2023), we are near the peak of the interest rate cycle. The interest rates on most fixed-income instruments, such as Government securities (G-secs), state development loans (SDLs), corporate bonds, etc., are at a multi-year high. The long-duration fund can lock into these high-yield securities and make regular interest income from them.
b) Capital gains
Going ahead, the interest rates are expected to fall. Long-duration bonds are sensitive to interest rate movements. When interest rates go down, bond prices rise, and vice versa. As a long-duration fund invests in long-duration bonds, it benefits from the fall in interest rates. When the interest rates fall, there will be a rise in the bond prices, resulting in a rise in the net asset value (NAV) of the long-duration fund units.
Also Read: Axis Bank And SBI MF Launches Long-Duration Funds. Should You Invest?
Who should invest in long-duration funds?
An investor looking to benefit from interest income (in the short run) and capital gains (in the long run) may consider investing in long-duration funds. From a personal investing angle, long-duration funds are a good investment product for long-term financial goals.
You need to build a long-term investment portfolio for long-term financial goals, such as building a fund for a child's higher education or own retirement. The portfolio can comprise equity funds, debt funds, gold, etc., for wealth creation. You can allocate some portion of the debt mutual fund portfolio to long-duration funds. When investing in a long-duration fund, your investment horizon should be 5 years or higher.
Risks involved in long-duration funds
Long-duration funds do well in a falling interest rate scenario. As discussed earlier, when interest rates fall, the prices of long-duration bonds rise. When the long-duration fund has long-duration securities in its portfolio, it benefits in the form of an increase in unit NAV (capital gains).
However, the opposite happens in a rising interest rate scenario. Long-duration funds are the most sensitive to rising interest rates. When interest rates rise, the prices of long-duration bonds fall. As a result, the long-duration fund's net asset value (NAV) falls. So, a rising interest rate scenario is one of the most significant risks for a long-duration fund.
The other risk for a long-duration fund is credit risk. If the fund invests in corporate bonds, there is a risk of the corporate either delaying the interest payment or defaulting on the interest and principal repayment obligation. If the fund has invested in G-secs, there is no credit risk as these are issued by the government and have a sovereign guarantee.
Also Read: What Are Focused Equity Mutual Funds? Best Focused Equity Mutual Funds To Invest In
Performance of long-duration funds
Currently, there are only a few long-duration funds in India. Out of the six long-duration funds (as of February 2023), 4 of them were launched less than six months back. Let us look at the performance of these funds.
Long-duration fund returns
Source: https://www.moneycontrol.com/mutual-funds/performance-tracker/returns/long-duration-fund.html
The above returns are as of 22 February 2023. The returns are for direct plans with growth option. The 6 months and 1-year returns are absolute, and the 3-year returns are CAGR. The funds have been ranked based on 3-year returns.
The above table shows how the 3-year returns for these funds have been less than 5% CAGR. These are not very good returns. However, we need to understand during the last 3 years, the environment was not favourable for long-duration funds to give good returns. The interest rates were low from February 2020 to the middle of 2022 due to Covid. From the middle of 2022 to the present (February 2023), the RBI has been increasing interest rates, which impacts long-duration funds negatively.
Currently, long-duration funds are benefitting from the accrual of high-interest rates on the long-duration bonds they have invested in. The situation will further turn favourable for these funds when the RBI starts cutting interest rates, which is expected to happen either at the end of 2023 or early 2024. So, you need not look at past performance. Your investment decision must be based on what is expected in the future.
Mutual fund houses expect the situation to turn favourable, so 4 AMCs have launched long-duration schemes in the last 6 months (as of February 2023).
Also Read: Ultra-Short, Low, And Short Duration Funds: Which One Is The Best For You?
Should you invest in long-duration funds?
As discussed earlier, you may allocate some portion of your debt fund portfolio to long-duration funds. You may start a systematic investment plan (SIP). Currently, interest rates are high. As a result, these funds will benefit from the interest accrual on long-duration bonds they invest in. Going ahead, when interest rates fall, the prices of bonds will increase, which will result in capital gains for these funds. When investing in long-duration funds, you should have a minimum investment tenure of 5 years. As part of your overall investment portfolio, long-duration funds are a good investment product for achieving your long-term financial goals.
In February 2023, the RBI hiked the repo rate to 6.50%. Many experts feel that we may be near the end of the interest rate hike cycle with a probability of 1-2 more rate hikes of 25 basis points in 2023. After that, the RBI may take a long pause and then start cutting interest rates once inflation is under control. Given this scenario, in this article, we will understand what long-duration debt mutual funds are, how they work, the risks involved, their returns, and whether you should invest in them.
What is a long-duration debt mutual fund?
A long-duration debt fund is an open-ended mutual fund scheme that invests in fixed-income instruments, such that the portfolio Macaulay duration is greater than 7 years. In simple terms, the Macaulay duration refers to the time (years) it will take the investor to recover their money invested in a fixed-income instrument (bond) through coupons (regular interest payments) and the principal repayment. As per SEBI guidelines, the Macaulay duration of a long-duration fund portfolio should always be more than 7 years.
a) Interest
Currently (as of February 2023), we are near the peak of the interest rate cycle. The interest rates on most fixed-income instruments, such as Government securities (G-secs), state development loans (SDLs), corporate bonds, etc., are at a multi-year high. The long-duration fund can lock into these high-yield securities and make regular interest income from them.
b) Capital gains
Going ahead, the interest rates are expected to fall. Long-duration bonds are sensitive to interest rate movements. When interest rates go down, bond prices rise, and vice versa. As a long-duration fund invests in long-duration bonds, it benefits from the fall in interest rates. When the interest rates fall, there will be a rise in the bond prices, resulting in a rise in the net asset value (NAV) of the long-duration fund units.
Also Read: Axis Bank And SBI MF Launches Long-Duration Funds. Should You Invest?
Who should invest in long-duration funds?
An investor looking to benefit from interest income (in the short run) and capital gains (in the long run) may consider investing in long-duration funds. From a personal investing angle, long-duration funds are a good investment product for long-term financial goals.
You need to build a long-term investment portfolio for long-term financial goals, such as building a fund for a child's higher education or own retirement. The portfolio can comprise equity funds, debt funds, gold, etc., for wealth creation. You can allocate some portion of the debt mutual fund portfolio to long-duration funds. When investing in a long-duration fund, your investment horizon should be 5 years or higher.
Risks involved in long-duration funds
Long-duration funds do well in a falling interest rate scenario. As discussed earlier, when interest rates fall, the prices of long-duration bonds rise. When the long-duration fund has long-duration securities in its portfolio, it benefits in the form of an increase in unit NAV (capital gains).
However, the opposite happens in a rising interest rate scenario. Long-duration funds are the most sensitive to rising interest rates. When interest rates rise, the prices of long-duration bonds fall. As a result, the long-duration fund's net asset value (NAV) falls. So, a rising interest rate scenario is one of the most significant risks for a long-duration fund.
The other risk for a long-duration fund is credit risk. If the fund invests in corporate bonds, there is a risk of the corporate either delaying the interest payment or defaulting on the interest and principal repayment obligation. If the fund has invested in G-secs, there is no credit risk as these are issued by the government and have a sovereign guarantee.
Also Read: What Are Focused Equity Mutual Funds? Best Focused Equity Mutual Funds To Invest In
Performance of long-duration funds
Currently, there are only a few long-duration funds in India. Out of the six long-duration funds (as of February 2023), 4 of them were launched less than six months back. Let us look at the performance of these funds.
Long-duration fund returns
Source: https://www.moneycontrol.com/mutual-funds/performance-tracker/returns/long-duration-fund.html
The above returns are as of 22 February 2023. The returns are for direct plans with growth option. The 6 months and 1-year returns are absolute, and the 3-year returns are CAGR. The funds have been ranked based on 3-year returns.
The above table shows how the 3-year returns for these funds have been less than 5% CAGR. These are not very good returns. However, we need to understand during the last 3 years, the environment was not favourable for long-duration funds to give good returns. The interest rates were low from February 2020 to the middle of 2022 due to Covid. From the middle of 2022 to the present (February 2023), the RBI has been increasing interest rates, which impacts long-duration funds negatively.
Currently, long-duration funds are benefitting from the accrual of high-interest rates on the long-duration bonds they have invested in. The situation will further turn favourable for these funds when the RBI starts cutting interest rates, which is expected to happen either at the end of 2023 or early 2024. So, you need not look at past performance. Your investment decision must be based on what is expected in the future.
Mutual fund houses expect the situation to turn favourable, so 4 AMCs have launched long-duration schemes in the last 6 months (as of February 2023).
Also Read: Ultra-Short, Low, And Short Duration Funds: Which One Is The Best For You?
Should you invest in long-duration funds?
As discussed earlier, you may allocate some portion of your debt fund portfolio to long-duration funds. You may start a systematic investment plan (SIP). Currently, interest rates are high. As a result, these funds will benefit from the interest accrual on long-duration bonds they invest in. Going ahead, when interest rates fall, the prices of bonds will increase, which will result in capital gains for these funds. When investing in long-duration funds, you should have a minimum investment tenure of 5 years. As part of your overall investment portfolio, long-duration funds are a good investment product for achieving your long-term financial goals.
