'The long maturity of these funds makes them well-suited for long-term financial goals such as saving for retirement or children's education or marriage.'
Should one consider investing in a long-duration fund (LDFs) at this juncture? That is the question many retail investors have been asking themselves vis-a-vis LDFs, a category that has been in the limelight over the past three months with four fund houses -- HDFC, SBI, UTI, and Axis -- launching their schemes.
A glance at the category's average return over the past year, a meagre 4.5 per cent, doesn't offer much encouragement.
LDFs are debt schemes which, according to the Securities and Exchange Board of India, must invest in bonds so that the Macaulay Duration of the portfolio remains above seven years.
The regulator hasn't imposed any restrictions in terms of the credit quality of bonds.
Most LDFs invest in government securities or in bonds having high credit ratings.
These funds can be actively managed, which means the fund manager can change the duration and the portfolio construct depending on his view on interest rates and other factors.
Most of these schemes, however, plan to offer a roll-down investment strategy, which involves buying bonds and holding them until maturity.
If more money comes in, the fund manager simply purchases more bonds of similar maturity.
With interest rates on the upswing since May 2022, yields on long-term bonds have turned attractive.
The average yield-to-maturity of these schemes is currently 7.53 per cent.
Even if the scheme, on an average, charges around 75 basis points, the net yield works out to 6.78 per cent.
Prospects of capital gains
While the Reserve Bank of India has not yet signalled the end of the rate-hike cycle, many experts are of the view that we are close to it.
If interest rates come down over a period of time, investors who put their money in LDFs will see capital gains, which will bolster the returns from these funds.
"LDFs are highly sensitive to interest-rate movements and sharp fiscal adjustments. They have the potential to deliver high capital gains in a policy easing or fiscal consolidation cycle compared to other product baskets," says Anurag Mittal, deputy head-fixed income, UTI Asset Management Company.
Gains booked on units of LDFs held for more than three years are taxed at 20 per cent with indexation.
"By investing towards the end of the financial year, investors can get an extra year of indexation, thereby making investments made at this time of the year more tax efficient, provided these funds are held for over three years," says Vishal Dhawan, founder and chief executive officer, Plan Ahead Wealth Advisors.
Interim volatility risk
Although LDFs may seem like a win-win bet, it is important for investors to be aware of their risks.
If inflation remains persistent, forcing the central bank to hike interest rates further, investors could suffer mark-to-market losses in the near term.
"The disadvantage of LDFs is that if you don't have a long term horizon, you will earn muted returns in case of adverse market movement," says Joydeep Sen, author and corporate trainer (debt).
Adds Mittal: "High duration works both ways. These schemes are subject to adverse mark-to-market movements in policy tightening or fiscal expansion cycles."
Should you invest?
Sen is of the view that if an investor has a long horizon and invests in an LDF having good credit quality, he could earn a decent return with zero or very little credit risk.
Dhawan also favours allocating some money to these funds. He, however, suggests a staggered strategy for entering them.
Investors keen on investing in a high-quality fixed income portfolio for the long term -- typically more than seven-eight years -- may opt for this category.
"The long maturity of these funds makes them well-suited for long-term financial goals such as saving for retirement or children's education or marriage," says Mittal.
However, given their volatile nature, he suggests that only investors who have the appetite to tolerate intermittent volatility, and who can stay invested for more than five years, should allocate 10-15 per cent of their fixed-income portfolio to these funds.
Check the portfolio's credit quality and the scheme's expense ratio before investing.
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