The importance of ‘duration in bond funds

The management of debt funds is in many ways different from equity funds and ‘duration’ plays an important role in determining the returns of these funds.

Most of us know how equity funds are managed. A fund manager invests in various stocks depending upon his research and the fundamentals of those companies. Depending upon the type of funds, he may invest in companies within one sector or various sectors. While a fund manager of debt funds definitely looks at the fundamentals to ensure that companies pay the principal and interest amount in time, there is one other facet that he has to manage, which is ‘duration’.

One of the most important factors that impact the bond funds is the interest rate. Based on how a fund manager perceives the movement of interest rate going forward, he invests in long-duration papers that are bonds that are maturing over a longer period such as 10 years or short duration paper that matures in next three months. Hence, if a fund manager expects the interest rate to rise in near term, he will preferably invest in shorter duration bonds and vice-versa.

Duration in a bond fund context measures the sensitivity of the prices of bond funds to change in interest rate. It is normally expressed in a number of years. Since interest rate and bond prices have inverse relation, bond funds value change depending upon the interest rate outlook and duration of bond funds. Therefore, in a falling interest rate scenario increasing the duration helps in better returns. However, in case of rising interest rate scenario short duration bond funds are expected to do better.

In the current scenario, when globally the interest rates are normalising and are likely to increase, we cannot take a different route. Therefore, even in Indian perspective, we believe rate cut cycle is over for now. Therefore, dynamic bond funds with shorter duration can be looked upon.