Understanding ‘Duration Management’ of Debt Papers – By Prof. Simply Simple TM

Understanding ‘Duration Management’of Debt Papers– By Prof. Simply Simple TM We have an idea about management of equity funds. Don’t we?

Equity Funds are managed by: 1.Identifying stocks based on research. 2. Understanding the macro-economic picture. 3. Selecting the right stocks. A good fund manager does that. & when he does that well, investors stand to make good gains.

If this is how equity funds are managed, then how are debt funds managed?

While, on one hand, debt funds invest in debt papers which need to give good fixed returns & be of good quality there is another aspect which is very crucial in debt fund management. And that is ‘Duration Management’ of the debt papers.

Based on the interest rate outlook, the fund manager decides whether he should invest in long duration papers maturing over a period of, say, 10 years or short duration papers maturing over a period of, say, 6 months.

But how is his decision of selecting long duration papers or short duration papers connected with the interest rate outlook?

Simply speaking, when interest rates are expected to go up, the debt fund manager would invest in shorter duration papers but if interest rates are expected to come down, then he would do the opposite and invest in longer duration papers.

This is how the story usually ends & people remember this like they would remember any other formula. This is where there is a need to uncover the concept of ‘Duration Management’!

And what better than taking ‘cricket’ as an example? When we think of cricket, the ‘IPL’ comes to our minds in a flash. So what has the IPL achieved?

At one level, it has strengthened the bench strength of the Indian cricket. Today, for example, we have enough fast bowlers, spinners, batsmen etc. Imagine when we went for the recently concluded T-20 World Cup, we had to leave behind Pragyan Ojha, who was the highest wicket taker of the IPL.

So what does this bench strength mean for the BCCI? At one level, it means that there are enough players available. Hence if the BCCI needs a replacement, they would be available.

It also means that BCCI will not want to sign long term contracts with players. Long term contracts mean long term commitments & with a strong bench strength, there is no need for the BCCI to enter into any long term commitments with any player as they have the choice of dipping into the bench whenever current players lose form.

Similarly when the fund manager thinks that the interest rates are likely to go up in the near future, it means that debt papers in the future will offer better rates of return for the investor.

So just like a strong bench strength offered options for BCCI driving them to enter into short term contracts with players, similarly the fund manager observes that since interest rates are likely to rise soon and that debt papers giving a higher interest rates would become available he too would invest in papers with shorter maturities so that by the time the interest rates rise, his papers have matured and he has cash to invest in the new papers.

Now what happens when the debt fund manager believes that interest rates is more likely to come down?

He just reverses his strategy and invests in long duration papers. Now how do we explain this?

Lets once again turn to cricket. You will recollect that at one point in time a couple of years back the Australian cricket team saw Glenn McGrath, Shane Warne, Mark Waugh, Steve Waugh, Justin Langer all retiring at more or less the same time. Suddenly there was a dearth of players and the bench strength dried up completely.

In such a situation what do you think the Aus. Cricket Board would could have done? They would typically get into long term contracts with their players so that they do not lose them to some county or club. The board would thus show more commitment. So even when there is dearth of players the long term contracts signed with the players would stand the board in good stead.

In such a scenario, the value of the player goes up due to the dearth of players. So if some county would want to grab a contracted player, they would have to pay a large price to the Australian Cricket Board for cancelling the contract!

In the same manner, if a debt fund manager feels that interest rates are coming down and that fresh papers in the future would bear a lower interest rates, he would naturally invest in currently available papers for a longer duration. By doing so, his money stays invested in higher interest bearing papers even in a lower interest rate regime.

Just as the value of the cricket player went up when there was a dearth of players and the Cricket Board could extract a price to walk out of the contract, in the same manner the value of the higher interest bearing papers too would go up and the fund manager too could extract a higher price by selling it in the market!

Hope this lesson has given you an idea of ‘Duration Management’ of debt papers.

I will be glad to receive your feedback on this lesson to understand if there any gaps. Your feedback will help me improve my lessons going forward. Also, if you wish to demystify any other concepts, please write to me on professor@tataamc.com Your feedback is my reward.

Disclaimer The views expressed in these lessons are for information purposes only and do not construe to be of any investment, legal or taxation advice. They are not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at your own risk and Tata Asset Management Ltd. will not be liable for the consequences of any such action.

Understanding ‘Duration Management’ of Debt Papers – By Prof. Simply Simple TM