A quick guide on how a Roll down debt strategy can help you achieve stability in your Fixed Income portfolio
The pandemic induced fund managers to take judicious steps to make sure their debt returns stay intact. Back in Feb-March 2021, a lot of the debt funds that investors thought would perform, delivered low returns, in some cases, even negative! (Yes, you heard that right, People did lose money in Debt as well). Thus, it has become crucial to manage your risk, not only in equities but in debt as well by following tested debt strategies that help mitigate this risk. Today, we’d like to talk about the nuances of a Roll down strategy and how it works.
Before we deep dive into the details of a Roll-down debt strategy, here are a few basic things to keep in mind:
Debt Mutual Funds invest in Bonds, Commercial Papers, Debentures, and similar fixed-income instruments.
Debt MFs / Bonds with longer maturity periods generally deliver higher yields due to higher risk.
Interest rates and Bond Yields (Returns) are inversely related i.e. when Interest rates go up, Bond yields go down and vice versa.
Bond prices and their yields are inversely related as well i.e. when Bond prices go up, Bond yields go down and vice versa.
Bond yields will decline as it gets closer to its maturity because it will be making fewer coupon payments, which also implies that the bond’s price would rise in value, often above its maturity value.
So what is the Roll-down strategy?
In simple terms, when you look at the fixed income curve a.k.a Yield curve for 1 year to 10 or 30 years, at times there are certain maturities that are attractive investment options. So what a fund manager does is,
He/she selects a certain Maturity basket. For Eg — If today in 2023, a fund manager finds a 2026 maturity period at an attractive value, the fund manager would invest his entire assets in this segment which will be held to maturity i.e., there will not be much churn/turnover in this portfolio and will be held till 2026.
Whenever the fund sees inflows and outflows, it buys bonds with a tenure similar to the residual maturity of the fund.
As time goes by, the fund will be “rolled down” i.e., in 2021- the fund will offer you a 5-year maturity, in 2022- the fund will offer you a 4-year maturity, in 2023- a 3-year maturity and so on and so forth.
Constant Maturity Strategy vs Rolled down Strategy
In the case of a more conventional fund, which follows a constant maturity approach, the fund manager, in a steady-state, keeps buying and selling bonds while keeping the portfolio maturity within this defined range. Based on his/her views on interest rates, the fund manager may buy longer-dated or short-dated bonds. However, the average maturity will oscillate within the band of two to five years.
On the contrary, the fund manager following the roll-down strategy will let the portfolio gradually roll down over the set duration of seven years to zero and then will reset it back to the original duration. Since maturity reduces over a period of time, the interest-rate risk also reduces. As the original maturity remains fixed, the fund is able to provide a predictable return profile.
Here’s a quick view of how both these debt strategies have performed against each other and the average of top 100 debt funds.
What’s the best time to invest in this debt Strategy?
Rolling down the yield curve is most suitable in a low-interest rate environment, with the rate rising or expected to rise. As the interest rate rises, bonds lose value. It is an interest rate risk and it impacts bonds with a longer maturity. If interest rates are expected to increase, then investors will tend to stick with short-term bonds as those are less susceptible to interest rate risk.
However, by doing such a thing, the investors are limiting their return to lower yields. It is when rolling down the yield curve becomes profitable. Investors can buy long-term bonds and benefit from the higher yield. But since they plan to sell before maturity, their interest rate risk is not as high.
So how do I select a Good Rolled down Strategy?
Selecting a fund depends on numerous factors which include its past performance, Fundamental quality i.e., its underlying holdings, fund manager history and many more. You can Identify a Rolled down debt strategy by looking at the maturities of the underlying holdings that the fund invests in. Usually, you will see various bonds/debentures with varying maturities between 1 to 5 years or even more in many cases in case the fund manager feels the next 10 years are a better segment to invest in. A prudent way of understanding this even faster and with more assurance would be to consult your Financial Advisor who specializes in such instruments.
So Should I invest in a Rolled down strategy?
Rolled Down Strategies suit well with conservative investors, who do not want to see too much volatility in their portfolios and want a more predictable return profile. You may invest in such funds from a post-Retirement point of view or any other goal where capital preservation is your main priority rather than capital appreciation. These funds generally have a high-quality bias i.e they invest in fundamentally strong debt instruments with minimal credit risk etc.
There are some Roll-down strategies that have been launched in the last 3–4 years that have provided favourable market conditions in time such as post the 2018 NBFC crisis, March 2020 ) right after the Covid Pandemic), and many more opportunities were 3 and 4 years Corporate and other AAA-rated bonds were available at 8% + which is phenomenal as compared to FDs and other traditional fixed income instruments. Currently, the RBI is maintaining an accommodative stance, meaning it will keep the interest rates low as the economy revives from the horrors of the Covid-19 pandemic. But as time goes on and there are signs of recovery, RBI would eventually have to raise the interest rates since they cannot be sustained at current levels forever. So it makes sense to invest in a rolled down strategy that has a 5–10 year maturity period to deliver better returns and mitigate interest rate risk.