Is it time for debt funds to go slow on roll-down strategies as rates harden?

Roll-down strategies of bond funds are useful when interest rates decrease. But as the interest rates are expected to go up, roll-down strategies may not appear as attractive to many. If you are one of those investors looking at roll-down strategies as an investment option, here are a few things you cannot ignore.

Liquidity injection and lower rates

After injecting loads of funds into the financial system and cutting interesting rates in CY2020 to fight the economic slowdown caused by lockdowns announced to contain the spread of the COVID-19 pandemic, rates are bound to go up following rising inflation. Experts, however, think that the pace of rate hike may be slow. “Over next one year Reserve Bank of India would reduce the surplus liquidity in the system gradually and then normalise (i.e., initiate small hikes) interest rates slowly,” says Joydeep Sen, Corporate Trainer – Debt.

If interest rates rise, investors holding medium to long-term bonds may see marked-to-market losses. Investors have been holding on to roll-down bond portfolios to pocket attractive yields available in these bonds, compared to very short-term bonds offering lower yields. For example, the bonds with slightly more than three years maturities are offering 5.1 to 5.2 percent returns compared to 4 percent returns offered by bonds maturing in one year.

Schemes have been identifying such attractive differences in various buckets and building roll-down strategies around them. Roll-down strategies call for buying bonds maturing at a certain time and holding on to them till maturity. If the scheme gets more money, the fund manager keeps adding bonds which will match the maturity profile of the original portfolio. So if a four year roll-down starts in January 2018 and the scheme gets more money in say July 2018, then the fund manager will buy bonds maturing in three-and-a-half years. The idea is to offer a relatively predictable return profile for investors who want to stay invested.

How fund houses are playing the strategy

For example, DSP Corporate Bond Fund initiated a three-and-a-half years roll-down in September 2018. The scheme now runs a modified duration of 0.59 years. Another scheme from the same fund house DSP Savings Fund- a money market fund runs one year roll-down starting in Jan-March quarter. Axis Banking & PSU Debt Fund another roll-down strategy scheme focusing on high credit quality bonds offering decent accruals has a modified duration of 1.32 years.

Target maturity plans launched in CY2020, too, are examples of roll-down strategies. Investors have been looking at these and Bharat Bond ETF for higher yield compared to money market funds. However, in all these funds where the maturities are more than four years away, the journey may be bit volatile if the interest rates move up. The marked to market losses on these portfolios may eat into the returns offered by the scheme. Investors however prepared to sit through the maturity need not worry as they should pocket the estimated returns (yield to maturity minus expenses) at the time of entry. “Mutual funds offering roll-down strategies will continue with it and if you can match your investment timeframe with the schemes’ maturity profile, then you can still consider investments into it if you want predictable returns,” says Vinod Jain, Principal Advisor, Jain Investment Planner.

For schemes where the roll-down has come to an end, the fund managers are carefully weighing their options. Take the case of Sundaram Banking & PSU debt Fund which saw a four year roll-down portfolio maturing in March 2021. The scheme’s portfolio is now actively managed and has a modified duration of 0.17 years.

“Till the time we get some clarity on how RBI wants to manage interest rates, it is better to stay away from long duration roll-down strategies. Investors keen on roll-down strategies should look for three year roll-down strategies. Active management can offer better risk adjusted returns at this juncture,” says Dwijendra Srivastava, Chief Investment Officer-Debt, Sundaram Mutual Fund.

DSP Corporate Bond Fund’s roll-down strategy will end in March 2022. The scheme may not immediately initiate another three-year roll-down.

Matching maturity with investment horizon

“In a roll-down strategy the entry point is important,” says Kedar Karnik, Fund Manager, DSP Investment Managers. “We have to assess the situation and then evaluate the schemes potential for another roll-down tenor,” he adds.

In a situation the roll-down comes to an end, the fund managers are more likely to go for active management till the interest rates move up. In some cases they may opt for roll-down strategies ranging between a year and two. Both these approaches expected to limit the interest rate risk. The former approach of active management of bond portfolios bring in fund manager risk as fund manager shuffles between long duration and short duration portfolios in search of higher returns than buy and hold approach of roll-down strategies. The one to two year roll-down strategies do cut the risk of interest rate risk, but the yields are relatively unattractive.

Sen recommends that investors hold on to their investments in roll-down strategies, provided their investment horizon matches with portfolio maturity of the scheme. As the time passes by the interest rate risk goes down with falling maturity and duration. For the roll-down strategies with relatively higher maturity (say more than four years), you have to be prepared to stomach intermittent volatility, he adds.

If you have a trading mindset and expect a rate hike soon, you can consider exiting long duration roll-down and re-enter after the yields move up. But this can be a risky adventure, if your call of rise in interest rates do not play out. Also, when you sell your existing investments, your gains are liable to tax and exit loads.

Jain recommends investing in actively managed dynamic bond funds or gilt schemes if you have more than three years’ timeframe.