How does one select a duration fund ?

How does one select a duration fund ?

How does one select a duration fund ?  well that also depends on what duration are the investments intended for . How short is “short” What are the key features of a short duration fund  and how does it compare over a long duration fund

To begin with, lets understand what types of duration strategies one could deploy. While there could be several, 3 main strategies are accrual strategy, dynamically/actively managed strategy, and traditionally managed with some combination of both (accrual and active)

Accrual Strategy :

Here the focus is clearly focusing on increasing / maintaining the accrual on the portfolio. The idea is to enjoy the carry return of the portfolio over the intended investment horizon. Capital gains, thru adding duration while is not the primary objective of such strategy, some gains maybe inevitable due to the roll down effect of the yield curve and / or MTM impact. Here, the fund manager may look to add some liquidity risk, by taking some higher yielding less liquid assets. This would help in overall enhancing the carry of the portfolio

From the Kotak product bouquet, Kotak Income Opportunities (erstwhile Kotak Credit Opportunities) follows this kind of strategy. The current duration of the fund is at 1.9yrs, with a gross portfolio yield of 10.25%. The fund tries to identify assets with high yield, at the same time not diluting the credit of the portfolio. This fund does NOT intend to take high credit risk to build up the portfolio yield. Income Opportunities implies investment in assets which could offering some attractive spreads relative to other asset classes. For instance even investments in CD at spread of just 10 bps under a similar maturity NBFC paper is an investment opportunity for this fund. Likewise investing in a manufacturing sector at 100 bps over a CD is also a potent opportunity. This fund has and exit load of 15m as we focus on accrual assets in the 12-24 m bucket. Ideal for investors looking to earn some carry on their fixed income portfolio as also get some interest rate exposure. Gsec exposure is usually Nil or around 5-7% of the portfolio.

Traditionally managed strategy : 

Here the focus is on creating a portfolio of quality corporate bonds of varying maturities, typically in the 1-3yr band. Gsecs also form a part of the portfolio at times, but more as a tactical call and not usually part of the core strategy. Gsecs tend to add or reduce duration for such type of funds. Our Kotak Bond short term would fall under this category. Here the average maturity, given the current market scenario is likely to be under 3yrs, and gsec usually doesn’t exceed 15% of the portfolio. The core portfolio largely comprises corporate bonds. This kind of a strategy plays a dual role of duration cum accrual by virtue of its portfolio construct – while at the same time currently does not intend to have excessive interest rate exposure

Actively/ Dynamically managed strategy :

Here again several strategies could be pursued. One could churn the entire portfolio in line with the view moving from 0% invested to 100% invested – a truly dynamic fund management strategy. The other  variant could be that one could actively manage a certain component of the portfolio while keep the core portfolio intact. Kotak Bond / Kotak gilt fund would come under this category. In case of Kotak Bond, the gilt proportion currently varies in the band of 25-30% on the lower side to 50-60% on the higher side. In the current market conditions, we feel this kind of portfolio management style is likely play out well as against complete churn on the portfolio. The rest of the portfolio continues to be invested in corporate bonds. Thus the duration is added or reduced predominantly through increase/ decrease in the gilt component – in line with the view of the fund manager. Gilt is also managed in a similar manner, where the invested portion varies from 60% to 90% depending on the market view and existing market conditions

Do strategies really matter ?

Interest rates move across various cycles, in response to growth in the system as also various other macro variables. It is an arduous task to execute every view through a single strategy. Hence there is a clear need to differentiate strategies based on view, risk appetite and intended investment horizons. Gsec market is the most liquid market available in India today, hence most fund mangers tend to use that as a potent tool to add/ reduce duration in fixed income. Corporate bonds trade at some spread over the sovereign curve, and hence are the derivatives of the gsec market. Usually therefore, one does not tend to do significant churns in this segment, unless there is  a significant change in view

We believe most fund management styles are centered around either of the 3 above within the duration space, and hence one needs to understand the risk reward trade off before investing in any of such funds

Interesting times in the fixed income market, where markets are caught in midst of slowing economic growth on one hand, and sticky inflation on the other side. We feel this could be an opportune time for investors to increase exposure to fixed income  as an asset class with benign / stable interest rate expectations going forward.