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If you have been investing in fixed-income investment schemes such as term deposits and are now looking for consistent returns with low volatility, debt mutual funds are perfect for you.
By investing in fixed-income securities like corporate bonds and treasury bills, debt mutual funds fetch you consistent returns without assuming any risks. They are less volatile than equities funds and are a tax-efficient investing strategy that can help you earn higher returns.
They are, nevertheless, influenced by interest rate cycles depending on their duration. Typically, the higher the duration of the fund, the greater the sensitivity to interest rate changes.
But how can you calculate the level of interest rate risk in a debt fund? Through Average Maturity, Macaulay Duration, and Modified Duration. These figures can provide crucial information about how future interest rate changes will affect the profitability of a debt fund scheme.
Read on to know more about it.
A debt fund is a type of mutual fund scheme that invests in fixed-income securities that provide capital appreciation, such as corporate debt securities, government and corporate bonds, and money market mutual funds.
They have a set maturity date and pay a fixed interest rate for the duration of the. As a result, debt fund returns are more predictable as well as provide consistent returns than equity funds.
Debt securities have a predetermined maturity period. The bondholder or investor receives the principal and interest in full at the end of the term. Since debt funds invest in a variety of debt instruments, it can be difficult to determine the maturity of each security. Instead, we simply look at its average maturity.
This is the average time it takes for all securities in the fund to mature. If a debt fund's average maturity is three years, all securities will mature in three years on average. However, if you check the maturity of each security, it may be different from three years.
The debt fund's average maturity changes when securities are near maturity or if the fund manager changes the portfolio. Only the securities in the fund's portfolio expire at the conclusion of the period, not the fund itself.
For example, suppose a debt fund is invested in 3 bonds with face values of Rs. 2000, Rs. 4000, and Rs. 6000.
Say, the time to maturity for these bonds is 2 years, 3 years, and 4 years respectively. The weighted total of these bonds will be-
WT of Bond 1 = Rs. 2000 x 2 = 4000
WT of Bond 2 = Rs. 4000 x 3 = 12,000
WT of Bond 3 = Rs. 6000 x 4 = 24,000
Now, the average maturity calculation of the debt fund would be-
Average Maturity of the Debt Fund portfolio = (WT of Bond 1 + WT of Bond 2 + WT of Bond 3) / (FV of Bond 1 + FV of Bond 2 + FV of Bond 3)
= (4000+12000+24000) / (2000+4000+6000) = 3.3 years.
The average maturity of the portfolio is 3.3 years.
Macaulay Duration is defined as the weighted average Macaulay duration of all securities in a debt fund. It is the time taken by the issuer of the bond to repay the principal from the bond's internal cash flows. A bond's Macaulay duration is directly proportional to the maturity date. The longer the maturity period, the longer the Macaulay duration.
You can examine the Macaulay duration to know the prospective impact of an interest rate change on the performance of a debt fund. - H3
For example, to calculate the Macaulay duration of a single bond in the debt fund, a few key elements are required. Let us assume the values of the given elements.
Face Value = Rs. 2000 (It is the price at which the bond was issued)
Coupon Rate = 12% (It is the annual interest rate offered by the bond issuer)
Annual Interest = ₹240 (The total interest payout received by the bondholder as per the coupon rate)
Based on this, the Macaulay duration formula is:
Macaulay Duration = Face Value / Annual Interest Payout
= 2000 / 240 = 8.3 years
While you don't need to calculate the Macaulay duration for your debt funds because it's available on the debt fund factsheet, you should be aware that a longer Macaulay duration signals more interest rate sensitivity.
Modified duration evaluates how much a fund's price varies as the interest rates or yield to maturity (YTM) change.
YTM represents a debt fund's prospective returns and the quality of the bonds in the scheme. Typically, a higher YTM shows that the debt fund scheme is invested in low-quality bonds carrying high returns but also a high level of risk as compared to lower YTM funds.
To maximize gains, high-risk investors may consider investing in debt funds with a higher YTM. Low-risk investors can choose funds with lower YTM that invest largely in high-quality bonds with low risk.
In simple terms, if a bond's modified duration is 4 years and the market interest rate falls by 1%, the bond's price rises by 4%. In contrast, if the market interest rate rises by 1%, the price of the same bond falls by 4%.
|Distinguishing Factor||Average Maturity||Macaulay's Duration||Modified Duration|
|Definition||The average maturity states how long it takes for all of the securities present in your debt fund to expire. The longer the average maturity, the higher the interest rate risk.||The Macaulay Duration of a bond indicates its average lifetime, taking into account the flow of future coupon payments.||Modified duration indicates how much the fund's price varies in response to changes in interest rates or yield to maturity (YTM).|
|How does it change||Only when the broker or fund manager trades the securities presently in the portfolio excessively or perhaps when the securities are about to mature.||It varies in response to changes in the price, the annual interest rate offered by the bond issuer, or yield. The shorter the Macaulay duration, the higher the annual interest rate.||Modified duration increases when the maturity increases and the coupon and interest rate decreases.|
Average maturity, Macaulay duration, and modified duration can all provide useful information on the interest rate sensitivity of a debt fund. You should have a thorough understanding of these values to maximize your returns while minimizing overall risk to your portfolio.
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