Investors in fixed-income schemes, floated by mutual funds in India, are usually told by their advisors that debt schemes with lower duration carries lower risk than debt schemes with higher duration.
Investors in fixed-income schemes, floated by mutual funds in India, are usually told by their advisors that debt schemes with lower duration carries lower risk than debt schemes with higher duration. This is drilled into the investor’s head when interest rates rise.
What’s duration? Duration can be equated to an average life of a fixed- income instrument, i.e, a bond with a duration of 3 years simply means that the average life of the bond — given periodic coupon payments — is 3 years. It can be simplified further by saying that for one basis point (bps) rise in interest rates, a bond with a duration of 3 years will see its price fall by 3 paise per Rs 100 face value. Mutual funds publish the duration of their portfolio in their fact sheets.
Steep, flat and inverted yield curves
In theory, the fact that lower durations carry lower risks is true. For example, a bond with a duration of 3 years will fall by 3 paise per Rs 100 face value, while a bond with a duration of 7 years will fall 7 paise per Rs 100 face value for every one bps (100bps = 1%, 1bps =.01%) rise in interest rates.
In theory, the yield curve (yields at which bonds of different maturities are traded) is an upward sloping curve, i.e, bonds with lower maturities (read duration) carries a lower yield to maturity (YTM) than bonds with higher duration. The simple explanation for this is that lower duration = lower risk = lower returns. A normal upward sloping yield curve will look like the one given in the chart.
The slope of the yield curve may not always be the same. The movements, along the yield curve, give rise to terms such as steep, flat and inverted yield curves. In simple terms, a steep yield curve signifies that the spread (the bps difference between yields of bonds with different maturities) between short maturity and long maturity bonds are above average (the yield on long bonds have moved up more than the short bond yields or short bond yields have moved down while long bond yields have remained the same).
In case of a flat yield curve, the spread between short bond and long bond yields have come down either by long bond yields moving down faster than short bond yields or short bond yields moving up higher than long bond yields. When yield curve is inverted, the short bond yields are higher than long bond yields.
Flattening yield curve
What does this mean for investors? It means that returns on their investments in fixed- income funds are subject to movements along the yield curve.
Smart fund managers will play yield movements to enhance returns.
Fund managers will increase or decrease the duration of their portfolios, based on their perception of movements along the yield curve. For example, in times of a flattening yield curve, portfolios of higher durations are better off than portfolios of lower duration. A simple illustration, given in the table, will tell you why.
This illustration tells you that as the yield curve flattens, Fund A with a lower duration portfolio has lost 75 paise (3x25) per Rs 100 face value, while Fund B has not lost any value.
This basic illustration carries a lot of significance to the lay investor in how returns can fall in fixed- income funds, even if the duration is low. Hence, just by looking at the duration, one cannot reduce portfolio risk, and this is true in the current bond investing environment.
To be continued
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