Long-duration funds are top-performing debt funds right now. Time to invest?

Long-duration funds have been the best performers in the debt fund space in the last year.

Their top-of-the-chart performance hasn't gone unnoticed. Investors have been flocking to this category in recent months. Net inflows over the past four months stand at Rs 4,372 crore, more than the combined inflows of Rs 4,333 crore recorded in the preceding 15 months. In fact, September alone saw net inflows of Rs 1,489 crore, the highest in the last 19 months.

New long-duration funds are making their way into the market as well. So far, four NFOs (new fund offers) have been announced in this category this year. Two have already been launched, while the other two— Franklin India Long Duration Fund and Mirae Asset Long Duration Fund —are currently open for subscription.

But does the recent surge in returns and investor interest mean you should jump on the bandwagon? Let's understand whether long-duration funds are worth adding to your portfolio.

Recent performance

Long-duration funds have delivered 11.4 per cent return on average over the past year.

But has this category always been a star? Not really. The five-year average return is a modest 6.88 per cent. Over ten years, it's 8.17 per cent.

This tells us one thing: the recent stellar performance is more of a hot streak than an all-weather phenomenon. So, what's behind this lucky break? Let's dig in.

Reasons for good recent performance

Before exploring the reasons, let's first understand the opposite relationship between bond prices and interest rates:

• When interest rates fall , existing bonds with higher interest rates become highly sought after. Investors flock to these bonds, eager to take advantage of their better returns, which drives up their prices due to the surge in demand.
  
• But when interest rates rise , the tables turn. New bonds, offering higher yields, steal the spotlight, making the older bonds with lower rates less attractive. As a result, investors ditch the older bonds and flock to the new ones, creating a sell-off that pushes the prices of the older bonds down.

This principle applies to all bonds but is more pronounced in medium to long-duration bonds, which are highly sensitive to interest rate changes.

Therefore, the longer the duration, the greater the price fluctuation, a concept known as interest rate risk .

And because medium to long-duration and long-duration funds typically have a substantial allocation in sovereign bonds, the performance of these funds is closely related to the dynamics of the sovereign bond market. Currently, the category median (read: average) exposure of sovereign bonds for medium- to long-duration and long-duration funds stands at 74 per cent and 96 per cent, respectively.

Therefore, the recent rally in sovereign bonds has significantly boosted the returns of long-duration funds over the past year.

And why have sovereign bonds done well? There are two primary reasons:

1. JP Morgan Bond Index inclusion : Indian government bonds were recently added to the JP Morgan Government Bond Index - Emerging Markets. This brought substantial foreign inflows, boosting demand and prices for these bonds.

2. Peaking rate expectations in India : Investors believe interest rates have peaked. This has led to expectations of future rate cuts, encouraging investors in existing bonds to lock in their attractive yields before rates decline.

The table below highlights the impressive performance of long-duration debt funds during rate-cut cycles and the subdued returns typically seen during periods of rising rates.

Long-term debt funds are clearly sensitive when it comes to interest rate movements.

Is there a more stable option?

Short-duration funds, on the other hand, have bonds with shorter maturities, making them less susceptible to interest rate swings. So, while long-duration bonds may offer higher returns, they come with higher volatility, whereas short-duration funds keep things calmer and more predictable.

This volatile nature of long-duration funds is clearly captured in the graph below, especially when you compare them with short-duration funds.

Over the past 10 years, the one-year average rolling returns of long-duration funds have swung wildly, ranging from a dip of -3.31 per cent to a high of 21.53 per cent. Meanwhile, short-duration funds have much fewer fluctuations, with returns ranging from 2.65 per cent to 10.86 per cent.

Long-duration funds' more eye-catching highs don't guarantee higher returns. The table below shows the returns offered in the long run are not worth the volatility you get.

Where you should invest

Long-duration funds thrive in falling interest rate environments or when rate cuts are on the horizon. While they can deliver jaw-dropping returns in the short term, their long-term performance tends to be a bit more, well, modest.

These funds are highly sensitive to interest rate changes, which are swayed by everything from inflation expectations to macroeconomic shifts and even geopolitics—making them more volatile than you'd expect, almost like equities in disguise.

However, the goal of investing in debt is usually to enjoy stable, predictable returns without excess volatility . So, these funds should only be a tactical play in your portfolio at best—something to take advantage of interest rate movements, rather than your core holding.

For smoother, steadier growth, short-duration funds can be your best bet.

Also read: These 3 flexi-cap funds have not cracked under pressure