Constant maturity debt funds gain in long term whether rates rise or fall (2024)

Passive investing is slowly catching up in equities and bonds. Passive bond strategies include buy and hold (B&H) and constant maturity debt (CMD). While the former is well received, the latter has not been explored much. So let us understand how constant maturity debt funds can make money for you.

When bond yields rise, bond prices fall and the reverse too is true. This is termed interest rate risk. When the duration of a bond's portfolio - a measure of the bond's interest rate risk calculated using maturity, coupon and current yield - is high, the interest rate risk is also high, and vice versa.

In the context of these facts, let us understand what works for CMD funds.

In the B&H strategy, bonds are held till maturity and coupons are reinvested. As the portfolio nears maturity, its duration reduces and interest rate risk decreases.

In the CMD fund, there is a difference. A fund manager buys bonds of pre-determined duration; as duration reduces, portfolios are rebalanced periodically to match the original target duration. The rationale is to keep the duration and interest-rate risks constant.

Bond fund investors make money through coupons received and capital gains on bonds.

Investors in CMD are worried about capital losses when interest rates rise. However, they know that although a scheme incurs marked-to-market losses as yields rise, the entire portfolio is rebalanced periodically. New bonds bought by the scheme are issued at a higher coupon. Coupon accruals increase for the portfolio with rising rates. Though capital losses are evident in the short-term, higher coupon accruals offset these in the long term.

To understand how this works out, consider a single-bond portfolio. The bond offers a 3% rate of interest to start with, and interest rates are estimated to increase by 50 basis points annually.

The duration of a bond, in the beginning, is considered to be four years, and it is sold when the bond's duration falls to three years. This leads to capital loss at the end of every year of approximately 1.5%. Hence, the net return at the end of year one will be 1.5% (3% coupon accrual minus 1.5% capital loss). The sale proceeds of the bond are used to purchase another bond with four years duration and which pays a coupon of 3.5%. At the end of the second year, the net return will be 2%.

As accruals rise in later years, the average cumulative return is equivalent to the initial yield at the end of seven years. Considering these factors, the average return converges to the initial yield after '2n-1' years (where 'n' is the target duration - in this illustration, it is four years).

So, when interest rates rise, investors may incur some losses initially. However, over a period of time, a coupon on a bond almost compensates for capital losses. When interest rates fall, investors may initially gain, but the average return will converge to the initial yield.

Hence, investors with long-term views can use this strategy irrespective of whether interest rates rise or fall. This means allocation to CMD funds is an option worth considering.

(The author is head of research-passive funds at Motilal Oswal Asset Management Company)

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