Last week, we explained what an accrual strategy is, in debt funds. We talked about how you can identify if a fund follows such a strategy and how to use such funds. The second main strategy that debt funds follow is duration. In this article, we’ll cover what a duration strategy in debt funds is, which categories follow duration, and whether you should invest in such funds.
The price-yield relationship
The yield of a bond is a function of its price and the coupon (interest rate) it bears. If the bond’s price rises, the yield of the bond falls. If the bond’s price falls, the yield rises.
Now, consider interest rates. When interest rates fall, the bonds that were issued earlier (before the rate fall) will have a comparatively higher coupon. There’s a scramble for these bonds as they’re more attractive. Bond prices will rise as a result. Theoretically, the gains will be such that the bond’s yield eventually equals the new interest rate. Purely from an illustrative angle, consider a 10-year bond with a 7% coupon trading at Rs 1000. If interest rates fall to 6%, the bond’s price will climb to about Rs 1073, at which point the yields will be more or less the same as the new interest rate. Conversely, should interest rates rise, the current bond’s price will fall. And that means the current bond’s yields will go up.
When a fund follows a duration strategy, it is trying to adjust the maturity of the papers it holds based on the stage of the interest rate cycle.
What is a duration strategy?
How does this translate into fund strategies? Different bonds have different maturities and coupon. A bond’s maturity plays a role in how sensitive it is to changes in interest rates. Typically, longer-term bonds are more sensitive and shorter-term bonds less so. Why?
Simply because in the long term, there’s a risk attached to both changes in interest rates and/or credit worthiness. By sensitive, what we mean is the extent of the price gain for every fall in interest rate or the extent of price fall for every rise in the interest rate. A more sensitive bond gains more and loses more compared to a less sensitive bond.
In a rate fall scenario, a longer dated bond, which was issued earlier will provide higher coupon (interest income) for a longer residual period. That means its demand will be higher and so its price rallies more. The converse is true when rates go up. A longer maturing bond that was issued earlier at a lower rate will deliver lower coupon for the rest of its life and will therefore fall more to adjust to the new rate.
So when a fund follows a duration strategy, it is trying to adjust the maturity of the papers it holds based on the stage of the interest rate cycle. These funds take a call on the direction interest rates are headed and build their portfolio to reflect that direction.
In falling rate cycles, a fund with a duration strategy will go for long-maturity bonds to profit off the bond price rise. When rates rise, the fund will typically go for shorter maturity bonds as coupon will be attractive here and will simply make gains off accruing the interest.
Longer-term bonds are more sensitive and shorter-term bonds less so. In a rate fall scenario, a longer dated bond issued earlier will provide higher interest income for a longer residual period and so rallies more.
Identifying a duration strategy
So how do you know if a fund is duration or accrual? We’ve covered the latter question in our article on accrual. On the duration side, the following will help you realise fund strategy:
- For funds to make gains off bond price rallies, the bonds need to be liquid and traded. This is best found in government securities (gilts) and next in AAA-rated and a good number of PSU bonds. When a fund predicts a fall in interest rates, it will primarily buy into long-term gilts. So if you see a fund loading up on gilts, you know it is trying to make profits off a duration strategy. For example, Kotak Dynamic Bond went from 18% in gilts in August 2019 to 43% now.
- Funds that are purely duration based will see portfolio maturities swing by a wide margin. When we say purely duration, we mean that the fund’s main strategy is to take calls on the rate direction and adjust portfolio accordingly. Maturities change quickly because funds can push the bulk of their portfolio into long-dated papers when rates fall, and then shift out and into short maturity bonds when the rate cycle moves up. The shifts in maturity can change widely even over the course of a few months or a few years. These are typically dynamic bond funds, long duration funds, and gilt funds (but note that the ability to shift maturity is restricted in some categories. More on this in the section on pros and cons of duration). To continue with Kotak Dynamic, the fund’s average maturity swung from less than 4 years in 2018 to 5-6 years in 2019. In 2020, it has been anywhere between 5 and 8 years. In another example, Tata Dynamic jumped from 2 years in mid-2019 to 6 years a couple months later to less than 5 years in the next few months and close to 10 years now. The graph below shows how portfolio maturities have changed for the dynamic bond fund category and gilt category.
- Funds that mix both accrual and duration, such as corporate bond funds, medium duration, short duration funds, and banking & PSU debt see less swings in maturity. These funds also tend to use AAA and PSU bonds more than gilts to profit off rallies, unlike dynamic bond funds which rely much more on gilts. Medium to long duration funds also fall into this accrual-plus-duration mix. For example, while corporate bond funds on an average had about 10-17% of their portfolio in gilts over the past six months, dynamic bond funds had over half their portfolios in gilt. Categories such as corporate bond primarily follow accrual strategy but will try to make profits on the side when rates fall.
- In a pure duration strategy, portfolio yields will not be the right metric to look at. Portfolio yields can be low during falling rate cycles as the yields on the underlying instruments fall. The real gain comes from the appreciation in the price of the gilts/bonds that the fund holds.
- In pure duration strategies, the volatility in returns will be higher whether you’re looking a 1-month period or a 6-month period or a 1-year period compared to funds that follow an accrual strategy. By volatility, we mean the fluctuation or the deviation in returns. Duration strategies can result in losses. More on that in the next section.
To summarise, dynamic bond funds, gilt funds and long-duration funds are the ones you can expect to follow a duration strategy. Corporate bond funds, medium duration, medium-to-long duration, short duration funds, and banking & PSU debt funds use accrual as their main strategy but will repurpose their AAA-bonds and use some gilts to book bigger gains when rates fall.
The pros and cons
If you see the 1-year returns for dynamic bond funds, gilt funds, or long duration funds, they are around 8.5-10%. Corporate bond, banking & PSU debt, short duration are at similar levels. This is primarily because of duration calls playing right.
Pro#1: Duration calls can help shore up gains when rates fall.
Falling rates will reduce accrual income. So by locking into bond price rallies when rates are cut, funds can still deliver returns when they follow a duration strategy.
Pro#2: Duration calls can deliver much higher returns than accrual in a favourable scenario.
Bond price gains, which translate into NAV gains, can be very sharp. For example, 1-year returns in some gilt funds have even moved above 20% late last year. So if you time your investment right, you could stand to make substantial gains in even your debt investment.
Which, of course, brings us to the cons – most important of which is that timing is key.
Con#1: Duration calls can go wrong.
Making profits off a duration strategy needs falling rates. This is a factor of RBI action, market perception of inflation, economic growth, government borrowing, corporate credit standings, and liquidity. Getting rate calls right is not easy, and if such a call goes wrong and a fund increases duration, it can lead to suppressed gains. Reversing calls can be equally tricky.
We saw this through 2017, where there was a lot of uncertainty over rate direction and funds that went long and stayed there posted poor returns. Similarly, if a fund does not move into accrual before the rate cycle turns up, it could wipe out the gains made already. And these calls between duration and accrual need to be done consistently, over the years.
Con#2: Returns will be volatile and more unpredictable.
Since a duration strategy is based on bond price potential, returns can be volatile and losses are well possible even on a 1-year basis. Gilt funds, for example, have been loss-making in 1-year periods about 4% of the time since 2012. They have delivered less than 5% a fifth of the time on 1-year periods, but at the same time delivered 9%-plus returns about half the time. Returns can also be low if the fund sticks to either duration or accrual to wait for the cycle to turn and the call to pay off. The table below shows the percentage of times the dynamic bond fund category and the gilt fund category generated losses in 1-month, 3-month, 6-month and 1-year periods from Sept 2015 to Sept 2020.
Con#3: Some fund categories won’t be able to shift duration easily.
Dynamic bond funds change durations to suit the rate cycle. So when interest rates are rising or high, they can move into shorter-term bonds and benefit from normal interest accrual. So theoretically, they can maintain performance across rate cycles – provided they get both duration and accrual calls correctly. But for gilt funds, while they can cut maturity short, they are still restricted in that they will need to hold only gilts. Therefore, during rising rate cycles, gilt funds can see low accrual. Long duration funds are even more restricted, because they have to necessarily maintain an average portfolio duration of 7 years. The other fund categories, being primarily accrual, have a lot more freedom to benefit from higher interest rates.
Using duration funds
So how do you put the pros and cons together to know if you should invest in such funds? As we did with accrual funds in our earlier artile we’ll look at it from a timeframe, returns, and income perspective.
Duration strategies are good only if you have a long-term timeframe of at least 3-4 years, and longer if you are going for gilt funds. This is because in the short-term, one, these funds can see poor returns. Two, volatility is higher and evens out only over time. Three, the long period gives time for funds to course-correct if they take wrong interest rate calls. Four, categories such as dynamic bond funds can also take credit calls when they shift to accrual and their portfolios can sport low-rated papers. This adds another layer of risk, which should be avoided in the short term.
This is why you will find gilt funds and dynamic bond funds, if any, only in our long-term section in Prime Funds. If you are able to time your investments based on the rate cycle, then you can have a shorter timeframe.
If you cannot handle volatility in your funds or the prospect of losses in a 1-month, 6-month or 1-year timeframe or low returns for longer 1-2 year periods, you should stay away from pure duration funds like dynamic bond, gilts, and long duration funds. Go for accrual funds as explained in the article on accrual.
The two tables below, reproduced from the article on accrual strategy, show the returns in the past few years for different fund categories.
While 1-year returns can shoot into the double digits, over time, you cannot expect the same to hold for longer periods. These high returns tend to normalise over time across rising and falling rate cycles. However, returns still do beat FDs and especially on a post-tax basis. Given that the interest rates have gone through multiple rises and cuts in the past 4 years, recent returns for gilt and dynamic bond funds look far more attractive than accrual funds. This may not hold in the coming years.
If you are comfortable with return volatility, then you can consider dynamic bond funds and gilt funds. Holding dynamic bonds alone can, however, be avoided given that they have both credit risk and duration risk. Use these funds along with high credit quality accrual funds. We’d suggest avoiding long duration funds (SEBI category) simply for the reason that they do not have the duration freedom that other categories do.
Duration strategies cannot be used to generate steady income through systematic withdrawal. Given the potential for losses in these funds and their volatility you may inadvertently wind up selling when returns are poor. If your income requirement and investible capital allows you to set aside a sum for at least 5 years, you can consider using gilt funds. Systematically withdrawing them post such a period will impact your portfolio less, even if your withdrawal happens in adverse rate conditions.