Long duration debt mutual funds and Gilt funds are topping the charts with average returns of 12% and 10.76% in the last one year respectively. Apart from outperforming the other debt fund categories, they gave superior performance than most equity fund categories as well. These testing times of Covid19 when most of the investors are disappointed by their investment returns, the double digit returns might attract some naive investors. But before taking a call, you should know the risks involved in debt mutual funds with a long term maturity.
What caused the out-performance by long duration and gilt funds?
Falling interest rates are pushing the returns of long duration and gilt funds up. There is an inverse relationship between price and interest rates. As interest rates go down, the older securities become much favorable as they were giving better interest rates. Thus, their prices move up and vice versa.
"The interest rates in the market have come down significantly in the last four months thanks to the dovish stance of RBI which has cut repo rates multiple times. With significant surplus liquidity in the banking system the yields have softened across the yield curve. As a result of this, while the past returns from most long term debt funds look very attractive," says Raghvendra Nath, MD, Ladderup Wealth Management.
The repo rate now stands at 4%, the lowest since the levels seen in 2000.
What are the risks of investing in long duration and gilt funds now?
Long term debt funds carry duration and interest rate risks.
"Long term gilts have 'duration' risk. So, the price of a long-term gilt falls more if interest rates rise. We have been in a decreasing rate environment and that has helped long term gilts, but this can change if the extensive QE restarts the global growth engine and leads to higher rates," says Gaurav Rastogi, founder & CEO - Kuvera.in.
Raghavendra Nath explains that most of the funds are currently running at YTMs that are close to 6%. After accounting for expenses, these funds should be able to return around 5.5 to 6% in the next three years if the yields remain at present levels. He says, "However there is a reasonable chance that the interest rates harden in the coming years. In such scenario the returns from these funds could be lower." This is interest rate risk.
Yield to maturity or YTM of a scheme is the total expected return of the portfolio if all the securities are held till maturity.
Where should debt fund investors invest?
Looking at the heightened uncertainty created by the economic impact of the pandemic, mutual fund advisors ask investors to stick to the highest quality instruments like - Banking & PSU funds, and short term funds. They say credit risk space is still avoidable.