Long vs Short Duration Debt Funds: Which One Should You Choose?

November 29, 2024 By: Naresh Saini0 comments

Debt funds are a preferred investment choice for individuals looking for safer options than equities. Among them, long duration funds have grabbed attention lately due to their high returns over the past year. But are these funds the right pick for all investors? Let’s dive into their performance, risks, and when they might suit your investment goals.

Why Are Long Duration Funds in the Spotlight?

Over the last year, long duration debt funds have delivered an average return of 11.4%. According to data from the Association of Mutual Funds in India (AMFI), direct plans of these funds have provided returns ranging from 11.27% to 12.42%.

This recent success has attracted investors and led to the launch of new long duration funds. However, it’s essential to understand whether this performance is sustainable or a result of unique economic conditions.

Comparing Returns: Long vs Other Debt Funds

Here’s how other debt funds performed over the past year:

• Medium to Long Duration Funds: 1-year returns ranged between 9.30% to 10.41%.
• Short Duration Funds: 1-year returns were between 8.67% to 9.94%.

Clearly, long duration funds outperformed. However, short and medium duration funds have shown greater stability and lower risk over the years.

Are Long Duration Funds Reliable for Long-Term Investment?

The performance of long duration funds depends heavily on interest rate movements. Let’s break this down:

1-Year vs 5-Year vs 10-Year Returns

• 1-Year Average Return: 11.4%
• 5-Year Average Return: 6.88%
• 10-Year Average Return: 8.17%

While the recent returns seem attractive, long-term data shows that such high returns are not consistent. Over five and ten years, their performance has been moderate, reflecting their dependency on market conditions.

Why Did Long Duration Funds Perform Well Recently?

Two key reasons boosted the returns of long duration funds in the past year:

1. Inclusion in JPMorgan Bond Index

Indian government bonds were added to the JPMorgan Bond Index, attracting significant foreign investment. This increased demand pushed bond prices higher, benefiting long duration funds, which primarily invest in government bonds.

2. Interest Rates Near Peak

Many investors believe interest rates have peaked and are expected to decline. This expectation drives demand for existing high-yield bonds, increasing their prices and returns.

Understanding the Interest Rate-Bond Price Relationship

The performance of long duration funds is tied to interest rates:

• Falling Interest Rates: Old bonds become attractive, leading to higher prices and returns.
• Rising Interest Rates: New bonds with higher yields become favorable, reducing demand for old bonds.

Since long duration funds invest 96% of their portfolios in government bonds, they are more sensitive to interest rate changes.

When Should You Consider Long Duration Funds?

Long duration funds work best during falling interest rate cycles. For investors willing to take risks, these funds can deliver high returns in a short period. However, their volatile nature makes them less suitable for long-term investments.

Ideal Scenario for Long Duration Funds

• Interest rates are expected to decline.
• Investors are looking for short-term high returns and can handle fluctuations.

Why Short Duration Funds Are Better for Stability

If your primary goal is stable returns with low risk, short duration funds are a more reliable choice. They are less volatile compared to long duration funds and perform consistently regardless of market conditions.

5-Year Returns Comparison

• Long Duration Funds: Annual returns range between 6.35% to 7.28%.
• Medium to Long Duration Funds: Returns range between 7.04% to 7.56%.
• Short Duration Funds: Annual returns range between 7.27% to 8.83%.

Clearly, short duration funds offer better risk-reward balance for long-term investors.

Risks with Long Duration Funds

1. High Sensitivity to Interest Rates: Fluctuations in interest rates directly impact their performance.
2. Volatility: Returns can vary widely depending on market conditions.
3. Unpredictable Long-Term Performance: While short-term trends may look promising, long-term returns can disappoint.

Why Long Duration Funds Are Not for Long-Term Goals

For long-term investors, debt funds should provide consistent and stable returns. Long duration funds, however, are influenced by changes in the interest rate cycle, leading to higher uncertainty.

The longer the investment period, the greater the likelihood of interest rate changes, making them unsuitable for steady income goals.

Where Should Debt Fund Investors Focus?

Given the risks associated with long duration funds, here’s what investors should consider:

1. Stability Over High Returns

Short and medium duration funds offer more predictable returns with lower risk.

2. Diversify Across Debt Funds

Instead of concentrating on one category, spread investments across short, medium, and long-duration funds for balanced risk and return.

3. Consult a Financial Advisor

Every investor has unique financial goals and risk tolerance. Seek professional advice before making investment decisions.

Top Performing Debt Funds by Duration

Short Duration Funds

• Offer stable returns.
• Ideal for conservative investors seeking lower risk.

Medium to Long Duration Funds

• Provide a middle ground between stability and potential growth.

Long Duration Funds

• Best for short-term opportunities during falling interest rate cycles.

Final Thoughts on Debt Fund Investments

While long duration funds have delivered stellar returns recently, this performance is driven by specific economic factors and may not be sustainable. For most investors, the stability and lower volatility of short duration funds make them a better option. Evaluate your financial goals, risk appetite, and investment horizon carefully before choosing a fund.

Disclaimer: This article is for informational purposes only. Please consult your financial advisor before making investment decisions.