Investor timeline: 6-12 months for tactical, 10+ years for long term

Long-duration funds have outperformed all other debt fund categories over the past year, delivering an average return of 9.8 per cent. Investors need to understand the risks in these funds and choose an appropriate investment horizon.

Invest largely in G-sec

According to the Securities and Exchange Board of India (Sebi) regulations, these funds must have a duration of more than seven years.

“Most of these funds invest a major percentage of their portfolios in government bonds or in state development loans (state government securities) as corporates in India generally do not issue significant amounts of long-dated bonds,” says Devang Shah, co-head of fixed income, Axis Mutual Fund.

Softening yields

The macroeconomic indicators have improved over the last couple of years. “We have seen good numbers on both inflation, especially core inflation, and current account deficit. The government seems committed to bring the fiscal deficit down from the Covid highs. All these factors have contributed to bringing the 10-year yield lower during the year,” says Pranay Sinha, senior fund manager-fixed income, Nippon India Mutual Fund.

On the international front, going by the Federal Reserve’s utterances, it appears that US interest rates have peaked. Indian government bonds also stand to gain from inclusion in the JP Morgan bond indices. Rate cuts are expected to begin in the second half of this calendar year. Bond market yields have rallied 25 to 35 basis points over the past year in anticipation. The high duration of long-duration funds has had a multiplier effect and led to mark-to-market (MTM) gains in these funds.

Outlook remains positive

Fund managers are bullish on interest rate cuts. “The Reserve Bank of India (RBI) in its monetary policy report forecasted that next year’s (2024-25) inflation would be 4.5 per cent. The repo rate is currently at 6.5 per cent. The 10-year government bond yield is still above 7 per cent. Our house view is that interest rates should trend lower,” says Shah. He expects the 10-year bond yield to trend towards the 6.5 to 6.75 per cent level over the next 12-18 months. The global scenario is also positive. “The rate cycle for most global central banks has peaked with a good probability that many will start the rate-cutting cycle this year,” says Sinha.

As yields soften, long-duration funds could register further MTM gains.

Risks over medium term

The rate cut cycle, which is expected to last for six months to one year, could be a shallow one of 50 to 75 basis points. “Once this rate cut cycle gets over, the cycle could reverse sometime in the future. Whenever interest rates move up, this category will underperform,” says Joydeep Sen, corporate trainer (debt markets) and author. The high duration of these funds will amplify their capital losses in such a scenario.

Who should invest?

Two categories of investors may invest in these funds. “The first is informed tactical investors keen to play the interest-rate cycle who are prepared to exit once the cycle turns,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

These investors should be mindful that if they get their entry and exit timings wrong, they could end up with losses. The second category would comprise investors who expect interest rates to decline over the long term, albeit at a slow pace. “Besides a long horizon, they should be prepared to put up with intermittent volatility,” says Dhawan. Sen says while tactical investors should have an investment horizon of around six months to one year, long-term investors should stick around for 10 years or more.

Investors need to understand the nuances of the debt market before they venture into these funds.

“They need to understand where the high returns in these funds have come from and not invest based on past year’s returns alone. They should also choose an appropriate horizon when investing in them,” says Sen. When selecting a fund, Dhawan suggests going for one whose fund manager has navigated multiple interest-rate cycles and whose expense ratio is on the lower side.