Long Duration Funds

Long duration funds are open-ended debt mutual fund schemes that invest debt and money market instruments with a Macaulay duration of the portfolio greater than 7 years. Macaulay duration is like an average wait time for all your money back from a bond, considering both interest payments and final repayment and helping you understand how sensitive the bond's price might be to interest rate changes.

They are suitable for investors comfortable with a higher interest rate risk and seeking capital appreciation over the long term, but they may not be ideal for those with a low-risk tolerance or short-term investment horizon. As of April 2024, this fund category has average assets under management (AUM) of Rs 13,004.73 crore with 9 schemes, with the oldest being more than 25 years old, and the category ranked 14th in the list of open-ended debt funds according to the Association of Mutual Funds in India (AMFI).

Source: AMFI website as of April 2024

While you should identify your risk profile and plan your financial goals before investing in long duration funds, here are some situations where they may fit in:

Alternative to Long Tenor Bank Fixed Deposits

As of April 2024, the annual return for long duration funds ranges between 6.98% to 8.11%. On the other hand, interest rates offered by large banks on comparable fixed deposits range between 6.5-7%, showing that they give you better returns than bank fixed deposits, although they are market-linked and can fluctuate.

Source: Valueresearch, SBI, HDFC Bank, ICICI Bank, BOB websites

Note: While long duration funds are good alternatives to bank savings accounts and fixed deposits, they are not insured like them. Up to Rs. 5 lakh per bank account are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC).

Risk-Tolerant Investors

These funds carry a higher interest rate risk than shorter-duration funds. Investors with a moderate to high-risk tolerance, who can withstand potential capital losses in the short term for the prospect of higher long-term returns, may consider these funds.

Longer Investment Horizon

Investors with a long-term investment horizon, typically spanning several years or more, may find long duration funds suitable. These funds are designed for individuals with financial goals that extend over a more extended period, such as retirement planning.

Portfolio Diversification

Investors looking to diversify their portfolios beyond equities may include long duration funds to spread risk. Investors with a lower risk tolerance who are uncomfortable with the volatility of stocks may find them more aligned with their risk preferences.

Expectation of Capital Appreciation

Investors seeking capital appreciation over the long term may find long duration funds attractive. These funds have the potential for capital gains when interest rates fall, increasing the value of existing bonds in the fund's portfolio.

Dividend Taxation

These funds pay out dividends when you invest in their IDCW (Income Distribution Cum Withdrawal) option. Dividends are taxed at your marginal income tax rate, and TDS (Tax Deducted at Source) at 10% applies to dividends received more than Rs 5,000 per AMC per financial year.

Long duration funds offer a range of benefits, as shown below.

Professional Management

Experienced professionals manage these funds using market analysis, interest rate tracking, and credit risk assessment to maximise returns. For example, HDFC Long Duration Debt Fund is managed by Shobhit Mehrotra, who has 25 years of experience in fund management. (as of April 2024) 

Lower Volatility

Compared to equity mutual funds, long duration funds tend to have lower volatility. They are generally less sensitive to market fluctuations, making them suitable for investors with a lower risk tolerance.

Potential for Capital Appreciation

Due to the inverse relationship between bond prices and interest rates, long duration funds have the potential for capital gains when interest rates fall. Investors can benefit from price appreciation in existing bonds.

Accessibility for Retail Investors

Long duration funds make it easier for individual investors to access the bond market, which may require a larger investment if buying individual bonds, whereas users can start investing in these funds for as low as Rs 100. This accessibility is beneficial for retail investors.

Long duration funds also face some drawbacks, as shown below.

Rising Interest Rate Scenario

Long duration funds are sensitive to changes in interest rates. When interest rates rise, the prices of existing bonds tend to fall. Conversely, when rates decline, bond prices may rise. Investors in long duration funds may face capital losses if interest rates move unfavorably.

Market Risk

Long duration funds invest in a mix of debt securities, and their performance is influenced by market conditions. Economic factors, credit risk, and overall market volatility can impact the fund's returns.

Credit Risk

Long duration funds may invest in bonds with varying credit qualities. A downgrade in the credit rating of the bonds in the portfolio could lead to losses.

Reinvestment Risk

When bonds within the fund mature or are sold, the fund manager must reinvest the proceeds. If interest rates are lower at the time of reinvestment, the fund may experience a decline in overall yield, affecting the income generated for investors.

Inflation Risk

Inflation can erode the purchasing power of fixed-income investments. If inflation rises unexpectedly, long-term funds' real returns may be diminished.

Liquidity Risk

Some long duration funds may invest in less liquid or harder-to-trade securities. In times of market stress, selling such securities may be challenging, potentially impacting the fund's ability to meet redemption requests.

Complexity and Duration Risk

Understanding the dynamics of long duration funds, including their duration, requires a certain level of financial literacy. Investors unfamiliar with these complexities may find assessing and managing their investments challenging.

Long duration funds offer investors a unique opportunity within the debt mutual fund category by focusing on debt and money market instruments with a Macaulay duration of over 7 years. These funds are designed for those with a high tolerance for interest rate risk and a long-term investment horizon, seeking potential capital appreciation and relatively stable returns. While they offer benefits such as professional management, the potential for capital gains in a falling interest rate environment, and accessibility for retail investors, they also come with risks like interest rate sensitivity, market risk, and credit risk. Investors should carefully assess their risk profile, financial goals, and understanding of these funds' complexities before investing, ensuring alignment with their broader investment strategy for achieving long-term financial objectives.