Are duration funds staging a comeback? Things to know

NEW DELHI: With bond yields falling over the past few months,

duration funds

that invest predominantly in longer tenure bonds have received a shot in the arm. Long duration

funds

have topped the mutual fund performance charts, clocking over 6.3% over the past three months, followed closely by gilt funds with 3.7%. Does this mean duration funds are making a comeback or should investors stay away?



Till recently, bond yields had been rising in response to bottoming out of interest rates. As the central bank embarked on the rate hike cycle, yields rose from 6.2% to over 8%.

Bond prices

are inversely related to interest rates and yields, so bond funds took a hit. Duration funds, including gilt funds and long duration funds, took a severe beating. This made shorter-term bond funds or accrual funds a safer proposition as they are less susceptible to adverse interest rate movements. However, of late, yields have climbed down significantly in response to a sharp cooling of crude oil prices and easing retail inflation. RBI’s decision to hold rates in its recent monetary policy review signalled a pause in its rate tightening cycle, cheering the bond market. The benchmark 10-year government bond yield slid nearly 60 bps from a four-year high of 8.12% in September to 7.51%. This led to the turnaround in performance of duration funds.

However, experts say this should not be construed as a platform for duration funds to flourish. Even if interest rates do not rise much in the near term, there is still a lot of uncertainty for the bond market to contend with. Oil prices remain volatile and can rebound. If trade war tensions between the US and China de-escalate and Opec decides to cut supply of crude oil, then international oil prices will shoot up quickly. This will erase some of the gains made by longterm bonds over the past few months. Mahendra Kumar Jajoo, Head, Fixed Income, Mirae Asset Mutual Fund, says, “Apart from see-sawing oil prices, there are concerns on the fiscal and political front.”

This uncertainty calls for investors to remain parked in shorter-term bond funds such as short and low duration funds. Till the time there is clarity on where the interest rates are headed or chances are higher for an extended pause in rates, the accrual strategy provides a safer avenue for bond fund investors. R. Sivakumar, Head, Fixed Income, Axis Mutual Fund, says both one-year and 10-year corporate bonds are at similar yields, offering no additional benefit for investing in long-term bonds. “The compensation for taking on additional duration risk is simply not adequate at this point,” says Sivakumar. Jajoo also points out that corporate bonds of around threeyear duration offer a good enough carry (return for holding the asset) besides a relative degree of safety, which makes short-term bond funds of similar duration a decent investment proposition.

Gilt funds and long duration funds make more sense when there is a clear direction towards softening interest rates. If you are worried about missing the bus when interest rates start heading south, it is best to also have some allocation to dynamic bond funds. These funds can realign their portfolio to take advantage of any sustained softening in bond yields. “It is better to play the interest rate cycle with a dynamic bond fund that has in-built ability to take risk when the situation demands,” suggests Sivakumar. However, investors will have to be picky in this space as very few dynamic bond funds actually deliver on their premise.

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