Quick Take: How to invest in duration funds

By Dhaval Kapadia |  27-12-22 | 

Interest rates and bond prices move in opposite directions. When interest rates rise, prices of bonds fall, and vice versa. So if you own a bond that is paying a 5% interest rate and rates rise, that 5% yield doesn't look as attractive. It's lost some appeal (and value) in the marketplace. To compensate, its price will fall.

Duration is measured in years. Generally, the higher the duration of a bond or a bond fund (meaning the longer you need to wait for the payment of coupons and return of principal), the more its price will drop as interest rates rise.

Please read What is Yield and YTM to understand this more clearly.

Fixed-income investors should allocate exposure to debt funds (short-term debt, medium and/long-term debt, and credit) based on their individual recommended asset allocation, which in turn is dependent on risk appetite.

Shorter duration funds (short duration, corporate bond, etc.) provide accrual yield and subject investors to relatively lower market-to-market risk.

Longer duration funds (medium-to-long, long duration, etc.) offer a higher yield compensating investors for the maturity (duration) risk, and present an opportunity for significant capital appreciation in a falling interest-rate cycle. However, these would deliver subdued performance when interest rates move north.

Funds taking exposure to corporate securities offer additional yield to compensate investors for taking on credit risk.

Investors should ideally follow a core-satellite approach, with the core (70%) of the portfolio invested into high credit quality (safer) shorter-duration funds to minimise credit and duration risks, while the satellite portion of the portfolio can be allocated to longer-duration and credit-risk funds.

To construct a debt portfolio, please read:

3 components of a smart debt portfolio

5 steps to build an all-weather debt portfolio 

More on Debt Investing

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