Why the mutual fund industry is betting on duration funds

Why is the mutual fund industry betting on duration funds?

The duration fund strategy is used in managing bond portfolios, focusing on their sensitivity to interest rate changes—bond prices and interest rates move in opposite directions: when interest rates fall, bond prices increase, and vice versa. The longer the duration (in years), the more sensitive the bond is to interest rate changes.

Consider a bond with a face value of ₹1,000, with a duration of five years, and an interest rate of 5%. If you buy this bond for ₹1,000 and the RBI cuts interest rates by 1%, the bond’s price would increase by about 5% (1% change in interest rates multiplied by the five-year duration). Consequently, the bond’s price would rise to ₹1,050.

In effect, longer-duration bonds provide higher returns to investors in a declining interest rate environment.

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The mutual fund industry finds duration funds particularly attractive now due to the anticipated interest rate cuts by RBI. If interest rates decline, investing in bonds with longer durations can lead to capital gains.

Other key factors that have an impact on duration funds are inflation, the external environment, and global interest cycles.

Easing inflation

According to mutual fund industry experts, India’s current inflation trajectory is favorable due to a combination of factors indicating a stable and controlled economic environment. These factors include stabilized commodity prices, effective interest rate measures to control money supply, and better-than-expected revenue collections. However, fluctuations in food prices remain a major concern.

"If the volatility in food prices eases, RBI will be more assured that inflation is heading towards its target of 4%," said Suyash Choudhary, head-fixed income, Bandhan AMC. “Core inflation is already quite low, and it is only the food price volatility that is standing in the way of monetary easing."

Improving fiscal dynamics

India’s improving fiscal dynamics indicate the government is effectively managing its finances. One crucial aspect of fiscal dynamics is fiscal deficit, which is the difference between the government’s total expenditure and its total revenue. High fiscal deficit can lead to inflationary pressures as the government may need to borrow more money, potentially increasing the money supply in the economy.

India’s fiscal deficit situation has improved in recent years. The government has been successful in controlling its spending while improving revenue collection, leading to a lower fiscal deficit of 5.6% of gross dometic product (GDP) for 2023-24 and an estimated 5.1% for 2024-25.

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“India’s inflation trajectory remains well-controlled partly due to a measured approach to fiscal stimulus," said Devang Shah, fixed income head at Axis AMC. “Also, the India growth story has been very strong, with GDP growth at about 7% for three years, which means when it comes to India’s rate dynamics, significant interest rate cuts are unlikely in the near future."

Shah said there is scope for a 50 basis point rate cut over the next 12 months. Even if rate cuts are gradual, other factors are driving the increasing interest in duration bonds.

External environment

Fund managers said India’s potential inclusion in major global bond indices such as the Bloomberg Bond Index and JP Morgan’s Index would bring in significant foreign investment. This influx will increase the supply of government bonds, creating favourable demand-supply dynamics.

“India’s inclusion in the Bloomberg Bond Index and JP Morgan’s Index will add about $30 billion put together. This translates to ₹2.5 lakh crore ( ₹2.5 trillion) into government bonds, which is 25% of our net supply of government bonds," said Shah.

Additionally, fund managers believe that while India does not have strong reasons to start cutting rates aggressively, the RBI will soon follow the global central banks. The European Central Bank and Bank of Canada have started cutting interest rates, and the US Federal Reserve is also expected to tilt towards rate cuts.

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“Improved fiscal dynamics allow the government to spend without affecting fiscal consolidation. Growth is reasonably robust. We don’t see any reason for building rate-cut expectations in India. However, we are bullish on duration only because of an improved fiscal position, which is much better than anticipated," said Rajeev Radhakrishnan, chief investment officer-fixed income, SBI Mutual Fund.

What do fund managers suggest?

Improved fiscal dynamics, including controlled government spending and efficient tax collection, have lowered fiscal deficit. This has reduced the government’s borrowing needs, supporting an environment of stable or falling interest rates. This, in turn, benefits long-term bond investments.

“The removal of tax benefits for debt funds has been a big disadvantage for retail investors. For medium-term debt investors seeking slightly higher returns than traditional options, short/corporate bond funds remain viable options," said Shah of Axis AMC.

“On the other hand, tactical investors seeking to capitalise on the interest rate cycle could consider investing in gilt funds. Their longer duration makes them more sensitive to interest rate changes, offering potential gains when rates decline."

Gilt funds are debt instruments that invest in government securities, offering safety and potential gains in a declining rate environment. But such funds can be volatile.

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Long-term debt funds are a good fit for investors willing to remain invested for at least seven years. These funds offer higher returns but can be volatile due to their interest-rate sensitivity.

Banking and public sector undertaking debt funds are ideal for medium-term investors (3-5 years). These funds provide stable returns with moderate risk, investing in high-quality debt from banks and PSUs.

Investors should be aware that duration strategies and investments in long-term bonds can be volatile due to their sensitivity to interest-rate changes. Seeking professional advice can ensure that your strategies align with your investment goals.