When investors move money into debt mutual funds, they often assume all such funds work the same way—but they don’t. Different debt funds adopt different investment strategies depending on the fund manager’s market view.
In a recent interview with Mint, Sahil Kapoor, head-products and market strategist at DSP Mutual Fund, said duration strategies look appealing right now because of wide spreads between the 10-year G-sec yield and the repo rate.
So, what exactly is a duration strategy? And what other strategies work in the bond market? Here’s a closer look.
Duration strategy
Duration funds take a directional call on interest rates. If the fund manager expects rates to fall, he increases exposure to longer-dated bonds.
The logic rests on a basic bond market rule: yields and bond prices move in opposite directions. When interest rates rise, yields go up and bond prices fall. When rates fall, yields decline and bond prices rise.
So, if interest rates are expected to fall, fund managers may take higher duration calls—meaning they increase allocation to longer-maturity bonds—because these bonds are likely to see price appreciation, boosting returns.
Longer-maturity bonds are more sensitive to changes in yields. A 10-year bond will experience a far sharper price swing for a given yield change than a 2-year bond.
This makes duration funds—particularly gilt funds, which invest in government securities (G-secs) and state development loans (SDLs)—well suited for this strategy. G-secs carry minimal credit risk since they are government-backed, but they do carry significant interest rate risk, especially at the longer end of the curve.
Accrual strategy
The accrual strategy takes a different approach. Instead of trading on rate movements, it focuses on earning steady interest income by buying bonds and holding them to maturity.
Returns here are driven primarily by the bond coupon rather than price appreciation.
In the current environment, many fund managers are leaning towards this approach.
“Quality 9- to 12-month commercial papers and bank certificates of deposit are yielding 7% plus now—decent compensation given that overnight rates are likely to stay in the 4.5–5% range,” said Dhawal Dalal, president and chief investment officer—fixed income at Edelweiss Mutual Fund.
What should investors do?
For most investors, shorter-duration, accrual-oriented funds may make sense as the core of their debt allocation right now. Returns in such funds are driven largely by interest income rather than rate bets.
Investors with a higher risk appetite could consider a small tactical allocation to long-duration gilt funds—but only as a satellite exposure.
The debt fund universe is more nuanced than just duration versus accrual. Liquidity conditions, rate stability, and macro factors also matter.
For short-term needs, money is better parked in funds anchored to shorter-dated bonds. For long-term debt exposure, investors may consider taking duration risk through long-duration gilt funds—but should remain mindful of potential price swings and higher volatility.