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On a high

Short-duration funds are increasing allocation to longer-duration bonds. While that's jacking up their returns, beware of the duration risk they are assuming

On a high

SEBI's reclassification exercise mandated the aggregate portfolio durations for various debt funds. Short-duration funds have to maintain a Macaulay duration between one year and three years. This limit applies at the overall portfolio level and funds have the flexibility to go beyond the three-year maturity mark at the bond level as long as the duration of the overall portfolio stays under three years.

Lately, short-duration funds are indeed putting this flexibility to good use. Though their investments in the bonds maturing over three years have steadily increased right from the time of reclassification, notably such allocations have spiked since the lockdown. As you can see from the graph 'Taking the highway', over a third of the assets of short-duration funds are currently parked in bonds with a maturity of more than three years.

Of course, there is wide variation across the funds. On the one hand, there are funds which have traditionally been more conservative in their approach and have barely gone beyond the three-year mark. On the other, there are the more aggressive ones, which have been stacking bonds well beyond even the five-year maturity mark. The fund charts depict how the allocations across different maturity buckets have shifted over the last one year in the 12 largest short-duration funds.

What's causing this?
Fund managers are increasing their allocation to longer-duration bonds as the gap between the yields of long-term and short-term bonds has widened. That's making holding long-term bonds even more rewarding. Given the fear of a slowdown as an aftermath of the pandemic, the central bank has cut interest rates and will likely keep them low. That has also hit the returns on short-term bonds. It's important for investors not to get swayed by the 9-10 per cent returns that some short-duration funds have delivered over the last one to one-and-a-half years. As things stand today, it will be optimistic to expect even a 6 per cent return from a high-quality short-duration fund in the next one year. The current yields to maturity of short-duration funds are generally around 5 per cent and that too before expenses. That's a far cry from the double digit returns you see in performance tables over the last one year.

In this context, the relatively better yields of long-duration bonds offer a viable option to fund managers to prop up the returns a bit. And this trend is likely to stay for at least the next few quarters. According to Shriram Ramanathan, who is Head - Fixed Income at L&T Mutual Fund and also co-manages L&T Short Term Bond Fund, "As of now the yield curve is very steep and the three- to five-year part of the yield curve offers a good carry. The yield curve may start moving higher after 1-1.5 years as the economy normalises, but at this point of time, our expectation is that it is unlikely to happen at least over the next couple of quarters. Thus, as regards L&T Short Term Bond Fund, we continue to have some allocation to the bonds maturing in three to five years."

What's the risk?
There shouldn't be much to worry till the time there's only a measured dose of such exposures, the portfolio quality remains high quality and the bulk of assets remain invested within the three-year maturity mark. However, investors, particularly those who have entered short-duration funds with a less than three-year investment horizon, can be watchful if their fund takes on significant exposures beyond five years.

"For L&T Short Term Bond Fund, as part of the fund's product positioning, we tend not to invest too much beyond the five-year maturity mark. In our view, the short-term bond category is not a category where we would want to expose investors to the risk of sudden sharp reversals in interest rates, which can cause large capital losses in longer-maturity bonds," says Shriram.