30 Oct Understand Duration
Vikram Betaal – Understanding Duration
Once again Betaal was out seeking Vikram. It had been a while since he had run into him; and the puzzle of “duration in debt fund investing” was giving him sleepless nights. But this was to change soon, as he spotted Vikram walking in the forest. And as usual, he flew towards him and landed on his back.
Vikram smiled. He too was expecting to meet his ghost friend.
Said Betaal, “Explain “duration” in debt funds. I need to know this in your style. Tell me or I shall crush your skull into many pieces.”
Vikram, never one to care about such empty threats kept smiling. However, Vikram loved the challenge of making concepts easy.
“So here we go Betaal with your lesson for the day. Imagine you are allowed to set up a food stall. In one case you get a contract to set up the stall in the market for just two days at a time. And in the second case you get to set up a stall for the entire year. Now tell me Betaal in which of the two cases you will you be able to forecast your sales better?”
Betaal thought for a while and said,”I will be able to forecast better if I sell for two days at a time rather than for the full year”.
“Exactly” said Vikram. “Because the duration is only 2 days your ability to predict is stronger. If it is two cold winter days, you will be able to predict less sales but if it is two days during spring, you could predict better sales. Again if it is two days during a storm you can expect nearly zero sales but if it is two days during a holiday season you can predict bumper sales. On the other hand if you have the contract of being in the market all year round it becomes hard to predict the overall outcome. If the year sees prosperity in the economy, a big event falling within the year, political stability etc you can have a great bumper year. But on the other hand, if there is unexpected bad weather, political instability, a war, etc your year can become very very disappointing. However, as you can see, it is a little difficult to assess the outcome of an entire year as compared to that of two days or even say a month”.
This is the principle of “duration”.
In a “debt” fund having low duration papers like a liquid fund, a short term bond fund etc and the impact of state of the economy on them is predictable. These funds are hence more stable. They may give higher or lower returns but they don’t exhibit “variations”.
On the other hand funds like “Dynamic Bond fund”, “Income Fund”, “Gilt Fund” that have “long” duration papers, and hence are extremely hard to predict.
Like the political and economic scenario that made it difficult to predict outcome of sales, the same parameters, likewise, affects the interest rate scenario of the economy and fund “returns”. But these are difficult to predict.
Even before Vikram could say anything Betaal spoke,”Wow, Vikram, that was the kind of explanation I had been longing for. Now I know why they say that long duration funds carry “duration” risk. For example now my mood is good and both of us know, that today, (in the short duration) I will spare you but who knows about another day in the long term?”
Saying these words and with a wide grin, Betaal took off from Vikram’s shoulders even as Vikram continued to walk with a cool and calm demeanor.
Author: Dharmendra Satapathy at NextLevel-Education