Given moderating inflation and the potential for the RBI to cut interest rates, is it wise to consider investing in Long Duration Debt Mutual Funds?
Many investors frequently encounter such questions when seeking returns from their debt portfolios. However, it is essential to consider the risks associated with investing in long-duration debt mutual funds.
Should you invest in Long Duration Debt Mutual Funds?
It is essential to have a clear understanding of the reasons for including a long-duration debt mutual fund in your portfolio. Merely assuming that a potential reduction in interest rates by the Reserve Bank of India will lead to higher returns from such funds does not provide the complete picture. Investing based solely on this assumption may lead to an incomplete assessment of the situation.
Before selecting long-duration debt mutual funds, it is advisable to consider the points outlined below before making a decision.
# Debt Portfolio is meant for diversification
It is essential to have a clear understanding of the reasons behind your selection of a debt portfolio. Generally, there are two scenarios in which one might consider a debt portfolio. The first scenario pertains to short-term goals, while the second involves long-term goals, particularly when you have already assumed the risks associated with equity investments. In this case, you may seek a stable asset class to offset the inherent volatility of equities.
Investors often focus on the returns or yields generated by their debt portfolios. This approach can significantly jeopardize the overall stability of their investment portfolios. While it is not necessary to adopt a completely risk-averse stance, it is crucial to avoid taking uncalculated risks by disregarding the potential dangers linked to debt investments.
# Don’t be in the wrong notion that Debt Funds are SAFE and Equity Funds are RISKY
The majority of investors have a firm belief that equity is a high-risk investment while considering debt to be a safer alternative, particularly since debt funds typically have no exposure to equity. However, it is important to recognize that debt mutual funds also carry inherent risks. In my observations, I have noted that even seasoned investors who excel in equity mutual fund investments often struggle to grasp the risks linked to debt mutual funds. Only the colour of risk will change between equity to debt. However, risk is always there in debt mutual funds.
# Understand these basics before blindingly investing in Debt Mutual Funds
I have already written various detailed posts on the basics of debt mutual funds. You can refer to them at “Debt Mutual Funds Basics“. These articles will give you clarity about the associated risks of debt mutual funds. However, trying to highlight few of them for your understanding.
a) Average Maturity – Average Maturity represents the weighted average of the current maturities of the bonds within a fund. Do remember that it’s AVERAGE but it does not mean all bonds are maturing at that maturity. Suppose, a debt mutual fund AUM is around Rs.10 Cr. The fund invested Rs.3 Cr in 4 years of maturing bonds, Rs.3 Cr in 10 years of maturing bonds, and Rs.6 Cr in 15 years of maturing bonds, then the average maturity of the fund is 13.2 years.
In the bond market, the duration of a bond significantly influences its price volatility, which is driven by supply and demand dynamics that anticipate future interest rates. Consequently, the average maturity of a fund serves as a strong indicator of its sensitivity to interest rate changes.
In simple, the greater the average maturity, the more susceptible the debt fund becomes to fluctuations in interest rates, resulting in a longer recovery period.
b) Interest Rate Risk – This risk is applicable to all categories of bonds. Bond prices fluctuate in reaction to variations in interest rates. This volatility in bond prices, resulting from changes in interest rates, is known as interest rate risk. The interest rate sensitivity increases with bond maturity. Because of this, you have to know when you need the money and make sure that the bond maturities in the funds don’t exceed the length of your investment period.
c) YTM – Yield to Maturity (YTM) refers to the expected returns on a bond if it is held until its maturity date. It is important not to solely rely on YTM when considering investments in such funds, as this may lead to the assumption of guaranteed higher returns. One must recognize that the holding period of a debt fund differs from the holding period of the investment itself. In essence, YTM provides insights into the anticipated interest rate trends, the risks associated with the fund, and the types of bonds included in the fund’s portfolio.
d) Credit Risk and Default Risk -SBI Bank, known for its financial stability, typically provides lower interest rates on its fixed deposits compared to those offered by cooperative banks. As the credit and default risks rise, the returns on bonds tend to increase as well. It is important to note that these ratings are not fixed and can change at any moment if rating agencies identify concerns with the issuing company. Therefore, it is advisable to steer clear of funds that hold low-rated bonds, even if their returns appear appealing.
e) Macaulay Duration – Macaulay Duration serves as a metric to determine the time, expressed in years, required for an investor to recover the initial capital invested in a bond through the bond’s interest payments and the ultimate return of the principal amount. In more straightforward terms, it represents the average duration needed to achieve a “break-even” point on a bond investment, taking into account both the periodic interest payments received and the total sum received upon the bond’s maturity. For instance, if a bond has a Macaulay Duration of 5 years, it indicates that, on average, it will take approximately 5 years for the investor to regain the amount invested in the bond. Additionally, this measure aids investors in assessing the sensitivity of a bond to fluctuations in interest rates. Bonds with extended durations exhibit greater sensitivity to interest rate changes compared to those with shorter durations.
f) Modified Duration – Modified Duration quantifies the sensitivity of a bond’s price to fluctuations in interest rates.
In straightforward terms, it indicates the extent to which a bond’s price will alter in response to a 1% change in interest rates. For instance, a bond with a modified duration of 5 suggests that a 1% rise in interest rates would result in an approximate 5% decline in the bond’s price. Conversely, a 1% decrease in interest rates would lead to an approximate 5% increase in the bond’s price.
This metric serves as a valuable instrument for investors to assess the risks associated with holding a bond amid changing interest rates.
# No economic cycle is permanent
Several years ago, prior to the onset of the Covid pandemic, we were experiencing a different interest rate environment. We are now gradually transitioning into a period characterized by lower interest rates. It is important to recognize that accurately forecasting such economic shifts is inherently challenging; no individual, not even the most esteemed financial managers, can claim to do so with certainty. Therefore, instead of relying on strategies formulated by self-proclaimed financial experts, it is advisable to maintain a stable debt portfolio (All-Weather Best Debt Mutual Fund Portfolio 2024 – How to Create?).
# Don’t chase YIELD from Debt Portfolio
It is essential to have a clear understanding of your motivations for examining a debt portfolio, as previously stated. Focusing solely on yield may lead to assuming greater risks than those associated with an equity portfolio. Therefore, if you are inclined to pursue higher risk, it would be more prudent to expand your equity portfolio. However, increasing risk within your debt portfolio could prove to be even more perilous.
Conclusion – Inflation may be showing signs of moderation, but this does not imply that it is a lasting phenomenon. It is merely a part of an economic cycle in which fluctuations occur periodically. Accurate predictions are inherently challenging, and unfortunately, the financial sector often capitalizes on this uncertainty. Therefore, it is advisable to avoid falling into this trap. It is essential to grasp the fundamental principles before pursuing returns without due diligence.
