3 min read.Updated: 05 Aug 2019, 08:09 PM ISTNeil Borate
Investors need to understand that high returns from long-term debt funds seen in the past one year are unusual and may not be replicated every year
Long-duration debt, gilt and other funds which buy high-maturity papers take a high level of interest rate risk
Long-term debt funds, including gilt funds, long-duration funds and in some cases dynamic bond funds, have had a good run in the last one year, drawing interest from a large swathe of investors. Speaking at the sixth edition of Mint Mutual Fund Conclave, held recently in Mumbai, chief executive officers of several asset management companies noted that there had been a sudden surge in long-term debt funds. The buying has been particularly high on mutual fund apps, which allow investors to directly invest in schemes (without distributors or advisers). Paytm Money, one of the largest mutual fund apps in India, said in a blog post recently that in the debt funds category, “gilt funds were the most bought on the platform" in June 2019. Gilt funds have posted average returns of 14% over the past year.
However, those entering this fund category at such a late stage may be walking into a highly risky gamble, said experts. Here’s why.
Where's the return source?
Long-duration debt, gilt and other funds which buy high-maturity papers take a high level of interest rate risk. When interest rates rise, their returns fall sharply and vice-versa.
Over the past year, interest rates in India have fallen on multiple rate cuts from the Reserve Bank of India (RBI). This caused long-duration funds to post stellar returns even as their credit risk cousins struggled with an ongoing crisis in the credit markets. The average one-year return for long-duration funds (as of 26 July) was 19.04% and for gilt funds 14.17%. In comparison, short-duration funds fared poorly giving 5.18% and credit risk funds gave just 0.69% average one-year annual returns (see graph).
The responsiveness of debt funds to interest rates is given by a measure called “modified duration". A modified duration of two means that a 1% cut in interest rate will cause a roughly 2% gain in the fund. Long-duration funds typically have modified durations of 6-12, meaning that they are hypersensitive to interest rate movements—you can pocket huge gains or losses based on interest rate changes.
Why does the fund make these gains? Typically, such funds have locked in government debt at high rates of interest. When interest rates fall, this older debt becomes more valuable. The opposite effect happens when interest rates rise.
Where do the risks lie?
Though the returns from long-term debt funds in the past year have been good, investors need to be mindful of two factors.
First, the gains these funds make from interest rate cuts are a one-off. Unless rates continue to drop in the same dramatic fashion over the next three to five years, such gains are not likely to repeat themselves. “In the last 20 years, a repo rate cut below 6% with an accommodative RBI stance has only ever happened on two other occasions. Even if rates go below 6%, they don’t sustain there for a long time," said Arvind Chari, head of fixed income and alternatives at Quantum Advisors Pvt. Ltd.
Second, interest rates can reverse themselves if inflation moves up. “Long-term average CPI is 5%, so repo rate can’t go too south of 6%. The rule of thumb, especially for retail investors, is to be cautious if you observe double-digit returns in debt funds," said Chari.
What you can do
When it comes to investing in long-term debt funds, experts advise caution. “The last three months have seen around 1% drop in the benchmark 10-year bond yield which had caused returns to surge. But most of the rally is behind us. People should look at short- to medium-term funds to benefit from the rate cycle," said Devang Shah, deputy head, fixed income, Axis Asset Management Co. Ltd.
If you have a financial adviser, speak to her before investing. “Investors who are investing directly, without the right advice, are likely to be drawn towards long-duration or gilt funds due to their returns over the past year. They should understand that such returns are unusual and not likely to be replicated every year," said Roopa Venkatkrishnan, a mutual fund distributor based in Mumbai.
“If you were lucky enough to be invested in these funds over the past year or so, now would be a good time to exit. The rally may extend a little bit more but you would be walking off with substantial gains even post tax," said Kalpesh Ashar, proprietor, Full Circle Financial Advisors and Planners, a financial advisory firm. “If, however, such funds are part of a long-term debt portfolio, then you can stay invested," he said.
Investors should be cautious while investing in these funds.