understanding ‘duration management’ of debt papers – by prof. simply simple tm
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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. - PowerPoint PPT PresentationTRANSCRIPT
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We have an idea about management of equity funds.
Don’t we?
Understanding ‘Duration Management’of Debt Papers
– By Prof. Simply Simple TM
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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.
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If this is how equity funds are managed, then how
are debt funds managed?
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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.
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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.
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But how is his decision of selecting long duration papers
or short duration papers connected with the interest rate
outlook?
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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.
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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’!
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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?
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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.
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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.
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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.
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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.
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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.
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Now what happens when the debt fund manager believes
that interest rates is more likely to come down?
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He just reverses his strategy and invests in long duration
papers.
Now how do we explain this?
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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.
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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.
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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!
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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.
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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!
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Hope this lesson has given you an idea of ‘Duration Management’ of debt
papers.
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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 [email protected]
Your feedback is my reward.
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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.
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