Know your debt funds: How to use long-term bond funds
The simplest type of a debt is a long-term bond fund. It is diversified across different kinds of fixed income instruments and is typically meant for long-term investments. The structure may be common, but making money out of it is a bit tricky.
What is it about?
A long-term bond fund is meant for investors who wish to make money over the long term, typically over a period of 3-5 years. Like we have always said, debt funds are to be chosen based on your investment tenure.
Hence, while other debt funds, like corporate bond funds and short-term bond funds are typically meant for horizons of up to roughly 3 years, the long-term bond funds are typically meant for the longer haul.
The average maturity of these funds is in excess of 3 years most of the times.
A long-term bond fund invests in a mix of corporate bonds and government securities (g-secs). Broadly, there are two types of long-term funds. One type of funds stay invested in long-tenured bonds and g-secs. The other type of funds are dynamic funds. In a falling-interest-rate scenario, their average maturities go up to around 7-10 years. When interest rates rise, they stock up lower-tenured instruments and keep the portfolio’s average maturity low.
Returns and risk
Long-term bond funds are meant to give you returns in excess of bank fixed deposits. And if held for more than 3 years, the returns are also more tax efficient. Expect these funds to return 8-10% over a 5-year period.
But it’s not always a smooth ride. Due to holding long-dated scrips, these funds can get volatile when interest rates in the economy suddenly change direction. Also, in a sustained rising-interest-rate regime, long-term bond funds give modest returns as they cannot sell long-tenured bonds and switch to shorter-tenured ones.
Value Research’s analysis of a series of 5-year returns over the past 10 years shows that debt funds have returned 2-12% returns. That’s a wide range, but a lot also depends on your fund manager.
Dynamic bond funds are more volatile. Here, your fund manager increases or reduces the fund’s average maturity drastically, depending on his view of the interest rates.
For instance, as per Crisil, Reliance Dynamic Bond Fund (RDBF) increased its average maturity from 12.86 years to 13.49 years in 2016 as the benchmark security, 10-year g-secs’ yield went down from 7.78% to 6.24%. When the 10-year yield moved up from 6.51% in December 2016 to 6.96% in April 2017, RDBF’s average maturity fell from 12.22% to 9.69% in this period.
Remember, if your fund manager’s prediction of interest rates go wrong, dynamic bond funds can lose a lot.
What’s so special?
Earlier, when there were fewer debt funds in the market, long-term bond funds were one of the few genuine, long-term income-generating opportunities with minimal volatility for the long-term investors. But over time, short-term funds and corporate bond funds have mushroomed, giving similar income-generating opportunities, but with much less volatility.
If you are looking to stay invested in a long-term bond fund for about 5 years or more, then alternatives like balanced funds and large-cap funds could work better for you.