Debt fund investors will benefit once interest rates begin to fall. But nobody knows for sure when interest rates will start to go down, although market experts have begun making predictions. Your investment strategy will depend on your time horizon. And that is why you need to understand the difference.
In the column on April 6 we looked at whether the Reserve Bank of India (RBI) rate hike cycle was coming to an end. In this backdrop, there are views in sections of the market that there would be a policy rate easing cycle ahead. It is an intellectual debate whether it is an RBI rate pause phase now or if rate cuts can be expected ahead. It depends on multiple variables, the major one being inflation.
What we will discuss today is the related concepts of duration funds and duration call, if at all we expect rate cuts.
How interest rate movements impact your debt funds
In fixed-income investments, the term duration has a different connotation from the general understanding of the word.
The variability of the price of a bond or the NAV of a bond fund in response to interest changes in the market is proportional to the duration of the bond / bond fund. The longer the maturity / duration of the bond / bond fund, the higher the variability and vice versa. This variability works both ways. When interest rates are coming down and bond prices are moving up, a longer-duration bond benefits more than a shorter-duration one, for the same extent of market movement. On the other hand, when interest rates are going up and bond prices are coming down, the adverse impact is more on longer-duration bonds.
So, in industry jargon, duration connotes long duration, which is preferred when interest rates are expected to ease, as you will benefit more than with a shorter duration.
What does a duration debt fund do?
Continuing with that connotation, a duration fund is a debt fund that runs a portfolio of long maturity instruments. There is no hard and fast definition of what is ‘long’. As a ballpark, residual maturity less than one year is money market, one to three years is short maturity, 5-6 years is medium maturity and 10 years or longer is long maturity.
The longer ones outperform other debt funds in an interest-rate easing cycle and underperform when interest rates are moving up. Ideally, you require a long investment horizon to come into a long-duration fund as the variability can happen either way, favourable or adverse.
What is a duration call?
As against a duration fund, a duration call is taking a view that interest rates are set to ease. This may happen on the RBI cutting rates or the market positioning itself for anticipated rate cuts. The implication of a duration call is that you do not have an adequate investment horizon to come into a long-duration fund. Your objective is to benefit when interest rates in the market are coming down, and exit. This is a quasi-opportunistic view.
In the current context, a section of the market is taking a view that the RBI would ease the repo rate. It may happen six months from now or one year from now. A duration call at this juncture is taking exposure to a long-maturity bond fund, say a G-Sec fund, with a portfolio maturity of 10 years or longer. If your investment horizon is, say, one year, it is a call or view-based exposure rather than a long-horizon investment to increase your wealth over a period of, say, 10 years.
If you are considering a duration call, you have to take care of the following aspects:
• Extent of rate cuts: Whether rate cuts will happen, when, and by how much, is anyone’s guess. But what can be said is that if there is a rate cut, it would be a shallow one. The repo rate is currently 6.5%, which more or less balances inflation control and GDP growth. From this near-optimum level, the scope for reduction is limited.
• Extent of market movement: In the absence of a popular index, we take the 10-year maturity G-Sec as a reference point. The repo rate being at 6.5 percent and the 10-year G-Sec being at approximately 7.2 percent, the spread between the two is 70 basis points i.e. 0.7 percentage points.
Historically, over the last two decades, this spread has been 1 percent on an average. That is, it is already lower than the long-term average. Even when the market factors in forthcoming rate cuts, the rally in the market would not be much. As an example, if the 10-year G-Sec rallies by 20 basis points, the market level would be 7 percent and the spread over repo would be half the historical average.
In a duration call, after the rally has happened, the accrual level, i.e., the rate at which interest accrues in the portfolio, is that much lower. If you book profits and move on to another debt fund, the accrual level would be more or less lower there as well. If you move on to, say, an equity fund, then you are changing asset classes altogether.
Source: https://www.moneycontrol.com/news/business/personal-finance/mc-explains-the-difference-between-debt-duration-fund-and-duration-call-choose-wisely-10443071.html