Explained: Is this the right time to invest in long duration debt funds?

• Long-duration debt funds are a category of mutual funds that primarily invest in fixed-income securities with extended maturity periods of seven years or more.
• Long-term bond funds tend to exhibit an inverse relationship with interest rates.
• Once interest rates start coming down as expected, investors in long duration debt funds will be benefited.

With the Nifty surpassing 22,000 and the Sensex above 73,000, the bulls are making merry on Dalal Street. Indian investors, seeking to ride the wave, are going gung-ho about mutual funds, especially in the small and mid-cap category, but debt funds are not in vogue.

However, investment gurus say that no investor should ignore debt funds because it is an important part of asset allocation. Moreover, at present, a category of debt funds, known as long duration debt funds, is creating a buzz. This is because currently the repo rate is 6.50% after the Reserve Bank of India (RBI) maintained status quo for the fifth consecutive time in its last policy. Before that the RBI had hiked the repo rate by 2.5% from May 2022 to February 2023.

“With the high interest rate regime behind us, interest rates are expected to reduce going ahead, aided by moderating inflation and crude oil prices. We expect RBI to cut interest rates in 2024,” says Ajaykumar Gupta, chief business officer, TRUST Mutual Fund.

If this unfolds, it is good news for long term debt funds. “A cut in interest rates would lead to additional gains in form of bond price appreciation, which would benefit investors investing in long duration funds,” says Gupta.

What are long duration funds?

Long-duration debt funds are a category of mutual funds that primarily invest in fixed-income securities with extended maturity periods of seven years or more.

“These funds, having a portfolio Macaulay duration of more than seven years as per SEBI mandate, typically invest in instruments like Government bonds, corporate bonds, treasury bills, bonds issued by banks etc., making them suitable for long term investors,” says Gupta.

Macaulay duration is a measure used in finance to estimate the weighted average time it takes for an investment to recover its initial cost in the form of present value of future cash flows, including interest and principal payments.

“However, there are different kinds of debt funds that can take a long-term debt fund kind of form- dynamic bond funds or gilt funds- fund managers can invest in long duration bonds,” says Pankaj Pathak, fund manager, fixed income, Quantum AMC.

Relation with interest rates

Long-duration debt funds tend to exhibit an inverse relationship with interest rates. Whenever interest rates fall bond prices move up and vice versa. When interest rates fall, mutual funds that invest in long-term bonds typically experience an increase in bond prices.

As bond yields move inversely to interest rates, the existing fixed-rate bonds held by these funds become more attractive. The higher bond prices contribute to capital gains for investors.

“If the interest rate goes up, the return of long duration debt funds comes down. If interest rates start coming down then the return of long duration bond funds go up. The credit risk of long duration debt funds is not that high as they invest mostly in government securities, but the interest rate risk is very high,” says Soumya Sarkar, Co-Founder, Wealth Redefine, an AMFI registered mutual fund distributor.


Source: Value Research

Should you invest in long duration debt funds?

Interest rates have seen a prolonged pause and thus fixed income proponents have been waiting for a pivot in stance.

However, investors are advised to go with a cautious approach. “If the interest rates go up or the yields go up from here, one may see a negative return, for a short period of time, but if one has a two to three year time horizon, the interest should come down and one should generate good returns,” says Sarkar.

The final word

Selecting a good long duration debt fund requires careful consideration of various factors.

“One must review the fund's portfolio holdings to understand the types of securities it invests in, including government bonds, corporate bonds, and other debt instruments. Further, one should examine the credit quality of the portfolio by reviewing the credit ratings assigned to the underlying securities,” says Gupta.


One might also evaluate the fund's performance by comparing it to both its benchmark and other funds in the long-duration category. Individuals contemplating long-term investments should thoroughly evaluate their risk tolerance, investment objectives, and time horizon before deciding to invest in these funds.