Should I invest in short term debt funds or long term debt funds?

I was listening to the Paisa Vaisa podcast on Trust AMC and got a better understanding of how mark-to-market pricing helps or hurts bond investors.

Mark-to-market pricing

Let’s imagine there are 2 mutual funds: 2YBF that invests in bonds that mature between 1 and 2 years and 1YBF that invests in bonds that mature in less than 1 year. Imagine a period of 1 or 2 years where the interest rate remains constant.

2YBF buys a 2-year bond that pays coupon (interest) of 4.5% per year. At the same time, 1YBF buys a 1-year bond that pays coupon of 4%. Remember these market rates; we’ll use these numbers later.

By the time the first year ends, the bond held by 1YBF would have matured and 1YBF will need to buy a new 1 year bond. The bond held by 2YBF is 1 year old and matures in a year from now. 2YBF cannot  invest in bonds maturing in a year or less, so this bond must be sold. 1YBF can buy this bond because 1 year maturity is what 1YBF wants.

If 1YBF buys 2YBF’s bond, it will have to pay more money than the principal + coupon that the bond will yield. The price will be set in such a way that 1YBF will get exactly 4% return, as that’s the market rate for a 1-year bond today. This is called mark-to-market pricing.

Interest rate movements and bond returns

From the above description, it might sound like buying longer duration bonds is better than buying shorter duration bonds. But it’s not that simple. Markets don’t give us more money without taking on more risk. In this specific case, 2YBF is taking on interest rate risk. If the market rate for 1 year bonds has gone up to 5% by the time 2YBF sells its 1 year bond, 2YBF will have to sell the bond at a loss.

This is how bond returns correlate with interest rate movements:

• Holding longer maturity bonds is good in a market where the interest rate remains constant or keeps falling. You lock in a higher coupon rate and hold it for a long time.
• In a market where the rate keeps rising, holding shorter maturity bonds is better. You can keep buying fresh bonds at higher and higher coupon rates.
• In a dynamic market where the interest rate fluctuates up and down, you cannot stick to a specific duration. Something like a dynamic bond mutual fund will allow the fund manager to generate alpha by tactically buying and selling. In the scenario where 2YBF had to sell the 1 year bond at a loss, the fund manager may (or may not) choose to hold that bond till maturity to avoid selling at a loss.

Does this mean dynamic bond funds are a good investment?

It’s hard to generalise like that because higher return always means higher risk. I looked at 1 year and 3 year rolling returns of a constant maturity gilt fund (which holds bonds maturing in 10 years) and 2 dynamic maturity gilt funds. While minimum return is attractive for the 10 year gilt fund, average return looks better for the dynamic maturity funds.

These funds are also volatile, and an investor who wants predictable returns would want to stick to nonvolatile funds (usually ones with maturity less than a year) or target maturity funds.

1 year rolling returns of dynamic gilt vs 10-year gilt (source: pimeinvestor.in)

3 year rolling returns of dynamic gilt vs 10-year gilt (source: pimeinvestor.in)