Reduce interest rate risk with maturity roll-down strategy
Over the past four to five years, bank interest rates have gradually deteriorated due to Reserve Bank of India’s (RBI) adoption of an accommodative policy to lift economic growth predominantly over the last couple of years.
In the month of May 2020, major PSU banks reduced their fixed deposit (FD) rates on one to three years maturity to 5.5 per cent. Besides, on a post-tax basis, returns on FD investment would be deplorable to many investors as they will struggle to bear inflation. As the economic growth has stalled due to the nationwide lockdown, interest rates are likely to tumble further.
Debt mutual funds also had their own challenges over the past 1.5 to 2 years. Credit risk was the major challenge that was faced by debt mutual funds. An acute liquidity crisis in non-banking financial companies (NBFCs) led to a series of credit rating downgrades and delay or default in payment by the issuers. Due to this, returns of several debt funds got impacted.
Further, debt funds are not just prone to credit risk but also, interest rate risk. Currently, in a falling interest rate scenario, the returns of debt funds would be affected. Though, in such a scenario, where funds with long-duration fetch more returns, are quite risky as they are more sensitive to interest rates that fund with a short duration. In such a situation, a maturity roll-down strategy helps you in reducing interest rate risk.
What is maturity roll-down strategy?
In bonds, with the passage of time, the residual time to maturity comes down. This phenomenon is known as maturity roll-down as the remaining maturity period comes down. In debt funds, interest rate risk is directly proportionate to the composite maturity of the fund. This means that a debt fund with lower composite maturity will have a lower interest rate risk as compared to a fund with higher composite maturity. Therefore, if a debt fund is passively managed, then with the passage of time, the interest rate risk would come down proportionately.
Most of the debt funds of open-ended types are actively managed funds. This means that the fund with a maturity of five years will remain the same at any point in time. Hence, they are prone to interest rate risk. In that essence, fixed maturity plans (FMPs) are passively managed products. Here, the fund house buys the bonds having maturity up to the maturity of the product. Therefore, in a three-year FMP, while initially designing the portfolio, the fund manager buys bonds with a three-year maturity. After one year, the remaining period of FMP would be two years and the residual maturity of the portfolio would also be two years. And when FMP matures, there is no interest rate risk. Therefore, FMPs are still prone to credit risk, unless they invest maximum assets in government securities.