Long-term debt funds, including gilt funds and long-duration funds, have performed excellently in the last one year which has drawn the attention of a large bunch of investors. These funds have not only outperformed the short duration funds but have also performed better than their long-term average and almost all equity funds. After observing these returns you might be curious to know if you can invest in debt funds for the long-term. But before answering that, let us first understand how the long term debt funds make such high gains or losses even though they primarily invest in fixed income securities.
How the debt funds make gains or losses?
Long-duration debt, gilt and other funds which buy high-maturity papers take a high level of interest rate risk i.e. when interest rate rises, their returns fall sharply and vice-versa. This responsiveness to interest rates is given by a measure called “modified duration". A modified duration of 2 means that a 1% cut in interest rate will cause a roughly 2% gain in the fund. Long-duration funds typically have high modified durations, generally between 6-12, meaning that they are hypersensitive to interest rate movements—you can pocket huge gains or losses based on interest rate changes.
Same thing has happened last year, when interest rates in India have fallen on multiple rate cuts from the Reserve Bank of India (RBI). This caused long-duration funds to post great returns compared to their credit risk cousins who have struggled because of the ongoing crisis in the credit markets. The average one-year return for long-duration funds (as of 26 July 2019) was 19.04% and for gilt funds 14.17%. In comparison, short-duration funds fared poorly giving 5.18% and credit risk funds gave just 0.69% average one-year annual return.
Where do the risks lie?
Though the returns from long-term debt funds in the past year have been good, investors need to be mindful of two factors.
The gains these funds make from interest rate cuts generally is a one-time gain. Unless rates continue to drop in the same dramatic fashion over the next three to five years, such gains are not likely to repeat themselves. In the last 20 years, a repo rate cut below 6% with an accommodative RBI stance has only ever happened on two other occasions. Even if rates go below 6%, historically they have not sustained there for a long time.
Interest rates can reverse themselves if inflation moves up. For example, currently the average CPI is 5% and therefore the repo rate can’t go below 5% under normal situation. The rule of thumb, especially for retail investors, is to be cautious if you observe double-digit returns in debt funds.
Should you invest in debt funds for long-term?
Now that you understand how the long term bonds have generated huge returns last year and how the same reason can result in huge losses or the loss of opportunity to generate huge gains in future, you should be cautious while investing in these funds.
If you have a longer investment horizon, it is suggested to have equity funds as your ideal preference. But if you are a conservative investor and do not want to venture into the equity space, then here are some debt funds which you might fit to your investment horizon, risk appetite and return expectation.
1. Medium Duration Funds
It is an open ended debt scheme that invests in debt/bonds and money market instruments such that the average maturity period is between 3-7 years.
2. Long Duration Debt Funds
It is an open-ended debt scheme that invests in debt and money market instruments such that the average maturity period is more than 7 years.
3. Gilt Funds
These mutual funds mostly invest in government bonds, which make it the safest investment. These are preferred by investors who are most risk averse.
4. Short Term Debt Funds
This refers to funds which invest in instruments with maturity of 1 to 3 years. This category of fund is usually accompanied by low risk and stable returns.
5. Liquid Funds
These are very short-term funds which can give you returns of 6-8% at minimal risk. These funds invest in high-credit quality, fixed income generating short-term instruments, which may include, certificates of deposits (CD), Commercial Papers (CP), Treasury Bills (T-Bills), etc.
To conclude one may say that debt funds are a good investment when one needs to park money for the short to medium term. In the long term, the effect of interest rate fluctuations can make the invest in debt funds quite volatile. If one has a long-term horizon for investments, equity funds may be a better idea. In case someone is looking to diversify the risk of investing in an equity fund, they could consider the option of investing in a balanced fund. Balanced funds consist of investments in stocks, bonds and money market instruments in a single portfolio.