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In fixed income investing, usually two broad types of strategies are employed ‒ hold to maturity or accrual and duration management. Within duration management strategies, some debt mutual fund schemes adopt active duration management strategy based on the fund manager’s outlook on interest rates while some adopt a passive duration management strategy, known as duration roll down or maturity roll down. In Indian mutual fund industry, most debt funds which take duration calls, actively manage durations. However in recent years, some fund managers are also using duration roll down strategies. In this article, we will explain the difference between the two strategies.

Duration Call

It is important to understand how fund managers use duration to generate returns for investors. There are two types of returns in debt funds ‒ income from interest paid by the bond and capital appreciation from the price change of the bond due to interest rate movement. Accrual based debt schemes aim to earn the interest paid by the bond by holding the bond till its maturity. Fund managers who take duration call, in addition to getting the yield (interest), seek to make profit from price appreciation of the bond if the interest rates decline. The duration of a bond is the price sensitivity of the bond to interest rate changes. Longer the duration of a bond, higher is its sensitivity to interest rate changes.

Active Duration Management

Fund managers who actively manage duration, invest in bonds of certain durations depending on their interest rate outlook. For example, if they expect interest rates to fall, they will invest in longer duration bonds. If they expect interest rates to rise, they will invest in shorter duration bonds within the scheme’s duration mandate. For example, let us assume a 10 year bond with 7.5% yield (interest rate) has a current duration of 7 years. If in 1 year, interest rate falls by 50 bps, then price of the bond will go up by = 7 (duration) X 0.5% (interest rate change) = 3.5%. Therefore, the total returns earned by the bond will be = 7.5% (yield) + 3.5% (price appreciation) = 11.0%. If fund managers get their duration calls right, they can generate good returns for investors.

Our objective in this article was to explain two different duration strategies used by debt fund managers ‒ active duration management strategy and duration roll-down strategy. Both the strategies have their merits. Both strategies are also exposed to interest rate risk depending on the duration profiles. We have shown that active duration management can generate good returns if the fund managers get their duration calls right. Funds using duration roll-down strategy are relatively new in India whereas top performing funds using active duration management strategies have long performance track records. Investors should understand how these two strategies work and make informed investment decisions. You should always seek the help of a financial advisor, if you want to understand the risk and return characteristics of your mutual fund schemes.

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