Why investors are into long duration debt funds despite the RBI repo rate hike

Long Duration Funds

Whenever interest rates go up, bond prices fall. The impact is the highest in long-term bonds, and schemes investing in them see muted returns and even losses. But the mutual fund numbers show a different picture this time. Though the Reserve Bank of India (RBI) has been hiking the repo rate since May 2022, investors are gradually investing in long-duration debt funds that invest in long-duration funds.

In the three months from November 2022 to January 2023, long duration funds (LDF) have seen net inflows of Rs 732 crore. LDF as a category managed assets to the tune of Rs 3,718 crore as on January 31, 2023. This indicates significant investor interest in these schemes. In the last six months, four fund houses — Aditya Birla Sun Life, Axis, HDFC and SBI — have launched LDFs.

Why LDFs are attractive

Investments in long-term bonds generally lose value when interest rates rise. However, smart investors sense an opportunity when the interest rates are nearing their peak.

“Upward pressure on bond yields is limited. We believe that most of the interest rate hikes are behind us. Current yields on long-term bonds are potentially attractive,” says Devang Shah, Co-head, Fixed Income, Axis Mutual Fund.

That makes a strong case for locking in current yields for long-term investments. According to Value Research, the yield to maturity stands at 7.48 percent and modified duration stands at 9.43 years for LDF on an average.

Most of these schemes invest in government securities, state development loans and high-quality bonds issued by private and public sector enterprises. Since the focus is on investing in long-term bonds, fund managers are seen limiting credit risks. Fund managers of LDFs cannot reduce the duration of the scheme below seven years. Many of these schemes prefer to roll down the portfolio maturity. The fund manager buys bonds with long enough maturity and then holds on to them. Incremental inflows are deployed in similar bonds maturing around the same time as the existing portfolio. Over time, the portfolio maturity keeps coming down and so does interest rate sensitivity.

Put simply, for an investor with a long-term view, this is akin to buying good-quality bonds offering high yields and holding on to them.

Who invests in LDFs?

An LDF is not for investors looking to make a quick buck. Though the interest rates are expected to come down in future and long-term bonds and LDF investing in them are expected to show capital appreciation, the timing of the downward movement in interest rates cannot be predicted.

“Investments in long-duration funds can be a tax-efficient way of investing in long-term bonds. These could be considered by long-term investors keen on compounding their money and building a large corpus for long-term financial goals such as funding retirement,” says Shah.

If investments in LDF (and all debt funds) are held for more than three years, then long-term capital gains that are booked are taxed at 20 percent post indexation. The high rate of inflation currently and high bond yields attract many high networth individuals looking for tax efficient fixed-income investments.

“High networth individuals looking to keep some money aside for the long term in fixed income are considering investments in LDFs since these schemes invest in high-quality bonds. Over the long term, the indexation benefit should help them generate healthy post-tax returns on their investments,” says Deepak Chhabria, founder and managing director of Axiom Financial Services.

Currently, investments in LDF compete with other tax-efficient options such as market-linked debentures and traditional life insurance policies. Budget 2023 has made these two less attractive after March 31, 2023. “Investments in LDFs will catch up post April 1, as that will be a long-term product with indexation benefits for high networth individuals,” said a fund manager with a leading mutual fund house, who is not authorised to speak to the media.

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Why not gilt funds?

Gilt funds invest in government securities with little credit risk. However, these have not seen inflows. In January 2023 gilt funds saw outflows of Rs 56 crore and their total AUM stood at Rs 16,329 crore as on January 31.

“Investments in gilt funds are generally done for tactical purposes with relatively shorter time frames. Such investors may still be worried about the possible upward movement in bond yields,” says Shah.

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On an average, the modified duration of gilt funds stands at 4.17 years. Fund managers awaiting confirmation of peak interest rates are yet to hike the duration. Savvy investors looking to benefit from falling interest rates wait for the fund managers to meaningfully raise the duration and downward movement in bond yields to begin in the secondary market.

“Long duration funds can invest in corporate bonds, which can offer higher yields compared to government securities,” says Amit Bivalkar, managing director and CEO, Sapient Wealth Advisors & Brokers. Gilt funds, however, restrict their investments to government securities. For now, most LDF are invested in government securities. However, if the spreads open up further, then investing in LDF will make sense over gilt funds, he added.

What should you do?

Investments in LDFs can be very attractive, especially at a time when yields are seen peaking. Investors with a long time on hand may consider some investment in this. Conservative investors worried about intermittent volatility should ideally go for staggered investments in such a scheme. Before investing check the expense ratio — the lower, the better. Also do not confuse these schemes with target maturity funds. These schemes cannot have a portfolio duration of less than seven years and hence they remain a high interest rate risk investment proposition. The only way to overcome this risk is to hold for a very long term.

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Do check if the scheme is adopting a roll down strategy and restricting investments to government securities. This information is available in the respective fund presentations and offers some idea about the risk level you are exposed to. Actively managed schemes with exposure to corporate bonds can be a tad riskier.