Long-duration funds: How to play them?
Debt mutual funds produced meager returns in 2020/2021 as central banks all across the world slashed interest rates. However, the rate hikes over the past 1 year have made this category look attractive. Analysts now expect this trend to reverse by the end of the year. Falling interest rates can make debt mutual funds, especially long-duration funds an appealing category to consider given its ability to generate equity-like returns over the short/medium term in such a macroeconomic environment.
Before we see how to let’s quickly understand the relationship between bond prices and interest rates. This will be fundamental in understanding how we can play the long-duration opportunity when interest rates fall.
Relation between bond prices and interest rates
Bond prices and interest rates have an inverse relationship; as interest rates fall, bond prices rise, and vice versa. This is because the fall in rates makes the existing debt instruments more attractive. For e.g. Let’s say you hold a bond paying a coupon of 8%. Then, interest rates for similar securities drop to 7%. Therefore, to compensate you for holding the bond — the price of that bond will rise in the secondary market to give new investors an effective return of 7%. The extent of the rise in price will depend on the duration of the bond.
Macaulay Duration
Macaulay Duration is a measure of the interest rate risk and quantifies how much the price of the bond will be affected by a corresponding change in the interest rate. Typically, the higher the duration of a bond or fund, the greater will its price rise as interest rates fall. The duration of a bond or a fund is computed by calculating the weighted average term to maturity of the cash flows from a bond. Simply put, if rates were to drop by 1%, a bond or bond fund with a 10-year average duration would likely gain approximately 10% of its value.
What Are Long-Duration Mutual Funds?
A long-duration fund is a type of mutual fund that invests in fixed-income securities, such as bonds, debentures, etc. with longer maturities. Typically, the securities held in a long-duration mutual fund have maturities of 10 years or more. These types of funds are designed for investors who have a longer investment horizon and are willing to tolerate the interim volatility in exchange for potentially higher returns. Unlike an accrual strategy, fund managers following a duration strategy take an active call on the direction of the interest rates and adjust their portfolios accordingly.
How Do Long-Duration Mutual Funds Work?
Like other mutual funds, long-duration mutual funds pool together money from multiple investors and use that money to purchase a diversified portfolio of securities. In the case of long-duration mutual funds, the portfolio will primarily consist of longer-term debt securities.
When an investor purchases shares in a long-duration mutual fund, they are essentially buying a portion of the fund’s portfolio. As the underlying securities in the portfolio mature or are sold, the fund’s manager will reinvest the proceeds into new securities with longer maturities, in order to maintain the fund’s overall duration.
Positioning your debt portfolio for a falling interest rate regime
As we can see, long-duration funds stand to benefit the most when interest rates are in a downward trajectory. Due to its higher duration, the NAV of the fund rises the most compared to other debt funds. However, more than other debt options timing is key here and the investor must be quick to act when interest rates move. Given its highly volatile nature, these funds can form a part of your ‘Satellite’ debt allocation with a 1-2 year holding period depending on the interest rate regime.