Do you know how to select Debt Funds: Modified Duration and Volatility

In this debt fund series, we are discussing different characteristics of debt fund. Our aim is to explain to our readers how debt funds work and empower them with knowledge of these products so that they can make the best investment decisions. In our post, Do you know how to select debt funds: understanding the risk, we discussed various risk factors in debt funds and also how risk of debt funds is different from risk of equity funds. In our post, Do you know how to select debt funds: types of Debt funds, we discussed about different types of debt funds, so that you can match your investment needs with debt mutual fund products. In this blog post, we will discuss some slightly advanced concepts of debt fund investing, so that you can make even more refined fixed income (debt) investment decisions.

In fixed income (debt) investing, primarily two types of investment strategies are deployed.

Hold till Maturity

This is also known as accrual strategy, by which the fund invests in certain types of fixed income securities (or bonds) and hold them till maturity of the bond, earning the interest offered by the bond over the maturity period. Let us explain how this strategy works, with help of a bond investing example.

Let us assume that, you have invested Rs 1 lakh in a bond whose face value is Rs 100 and a coupon of 8% (due in 6 months), maturing in 2 years. Let us suppose, you paid Rs 101 to buy the bond. You will purchase 990.1 bond units. Let us suppose, yields (interest rates) go up after you buy the bond (bond prices fall when interest rates go up and vice versa) and the price of the bond after one month is Rs 98. The book value of your investment will be Rs 97,030. So notionally, you have made a loss of Rs 2,970. After 6 months, you get a coupon (interest) payment of Rs 7,920 (8% of Rs 100 times the number of bond units, 990). Next year, you will again get a coupon payment of Rs 7,920. When the bond matures after two years from purchase, you will get the face value. The maturity amount for you will be Rs 99,010; add to it the coupon (interest payment) and the total money you get from your investment will be Rs 114,940.

So overall, you made a profit of Rs 14,850 on your Rs 1 lakh investment, though at one point of time, you were making a loss of Rs 2,970. Even though, you were making a loss of Rs 2,970 one month after investing, by holding the bond to maturity, you made a profit of Rs 14,850 irrespective of the price fluctuations in between. The price of the bond may have even gone down to Rs 95 from your purchase price of Rs 100, but price fluctuations will not matter, if you hold the bond to maturity. This is the essence of hold till maturity strategy. The main investment objective of hold till maturity (accrual strategy) is stable income. Therefore, if you want to get stable returns, then you should invest in debt funds which hold bonds till maturity. Short term debt funds, credit opportunities funds, Fixed Maturity Plans, ultra-short term debt funds, liquid funds etc are examples of funds which hold bonds till maturity.

Duration Calls

Using this strategy the fund manager, takes a view on the trajectory of interest rates. Bond prices go up when interest rate falls and declines when interest rate goes up. Why? Suppose you bought a 20 year bond with a coupon (interest) of 9% at face value of Rs 100 a year back. If interest rate goes down by 1% during the year then bond yields will decline; in other words, new bond issuers will offer lower coupon (interest) rates. Since your 20 year bond will pay you higher interest rates than what current yields are, investors who wish to earn the higher interest rate, will be ready to pay more than Rs 100 for your 20 year 9% coupon bond. You can sell your bond which you bought at a face value of Rs 100 at a higher price and earn a profit, over and above the coupon payment you received in the last one year. Please note that, if interest rate rises, the price effect on the bond will be exactly the opposite.

The price sensitivity of a bond to interest rate changes is directly related to the maturity of the bond. Why? It is fairly intuitive. If you bought a bond with 9% coupon and residual maturity of 10 years, assuming interest rates decline, you will be getting a higher interest rate for a longer period of time compared to an investor who bought a bond with 9% coupon and residual maturity of 1 year. Therefore, bond investors will be ready to pay a higher price for longer maturity bonds compared to shorter maturity bonds when interest rates fall. Please note that, if interest rate rises, prices of longer maturity bond will fall more than shorter maturity bonds.

If you want capital appreciation along with income, then you should deploy duration call strategy, or in other words, invest in long maturity bonds when interest rates are expected go down. Long term debt funds like Long Term Gilt Funds, Income Funds and Dynamic Bond Funds etc are examples of debt funds which take duration calls based on interest rate expectations.

Yield to Maturity and Modified Duration

We will now review two important fixed income (debt investing) concepts. It may get a little technical from here onwards for some readers, but for the benefit of all our readers, we will avoid mathematical equations entirely. Let us try to understand the concepts and more importantly, learn how to use it to make investment decisions. The two concepts that we will discuss next are Yield to Maturity and Modified Duration.

Yield to Maturity:

Yield to maturity (YTM) is the return which a bond investor will get by holding the bond to maturity. For a debt fund, it is the return which the fund will get by holding the securities in its portfolio to maturity. For example if a debt fund’s portfolio has a YTM of 10% and a duration of 2 years, it means that, assuming no change to the portfolio, the fund will give 10% returns (before expenses), as long it holds the securities in its portfolio till they mature, i.e. for 2 years. If the expense ratio of the fund is 1%, then the return to the investor will be 9%.

How to use YTM in investing? You can find out the YTM of a debt mutual fund scheme from the monthly factsheet (mutual fund research websites also show YTMs of debt funds). Higher the YTM, higher will be the returns in accrual based debt funds. However, as discussed in our post, Do you know how to select debt funds: understanding the risk, fund managers can get higher YTMs by investing in lower rated papers. Therefore, you should make sure that you are comfortable with the credit risk of the fund. You can find the credit risk profile of a fund’s securities in the factsheet. If you do not want to take credit risks, select funds which invest primarily in AAA or AA rated papers.

Modified Duration:

Modified duration is a fairly simple concept, but readers will have a better grasp of the concept if they first understand what Macaulay Duration or simply Duration is. Macaulay Duration is the measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows of the bond. Remember there are two kinds of cash flows in a bond, interest payments and principal payment. Some bonds pay the interest along with the principal on the maturity of bond. These are known as zero coupon bonds. Zero coupon bonds in India are issued at a discount to face value and you will get the face value on maturity. The duration of a zero coupon bond is the same as the maturity of the bond. However, there are some bonds which make interest payments also known as coupon payments to the investors at fixed interval, e.g. yearly and the principal is repaid on maturity. These bonds are known as vanilla bonds. Since a vanilla bond makes coupon payments on a regular basis to the investor, the investor recovers his investment well before the maturity of the bond.

Let us assume you invested Rs 100 in 20 year 10% coupon bond. If your bond pays 10% coupon, in other words, interest of Rs 10 every year, you will recover your investment in 10 years, much before the maturity of the bond. The duration of a vanilla bond is less than the maturity of the bond.

Let us now discuss what modified duration is. Modified duration is simply the price sensitivity of a bond to changes in yields or interest rates. So if the modified duration of a bond is 10 years and interest rates go down by 1%, then the bond price will increase by 10%. It is natural for some readers to wonder, why is price sensitivity of a bond called Modified Duration? It is called Modified Duration because mathematically it is very similar to Macaulay Duration (or simply Duration). Both Modified and Macaulay Duration are expressed in years and calculated using the price coupon rate and maturity of the bond.

How to use Modified Duration in Investing? You can find out the Modified Duration of a debt mutual fund scheme from the monthly factsheet (mutual fund research websites also show Modified Durations of debt funds). If you want to minimize interest rate risk, then select funds with low modified duration (2 years or less). If you expect interest rates to decline in the future and want capital appreciation, then select funds with higher modified duration. If you have a high risk appetite you can choose funds with modified duration of more than 5 years. If you have moderate risk appetite, then choose funds with modified durations of 3 to 5 years.

Suppose you choose a fund whose modified duration is 5 years and YTM is 9%. Let us assume expense ratio of the fund is 1%. You expect interest rates to go down by 50 bps during the year. Your return will be = YTM + Interest Rate Change X Modified Duration – Expense Ratio = 9% + 2.5% - 1% = 10.5%. When forming return expectation, it is also prudent to understand the risk. Let us assume that interest rate goes up by 50 bps during the year, your return will be = 9% - 2.5% - 1% = 5.5%.

You should make investment decisions based on risk return trade-offs. Remember risk is always a function of probabilities. If the probability of the favourable event (in this case interest rate declining) happening is high, you should see how much you are gaining. Let us assume the alternative investment to long term debt fund was fixed deposit giving 6.5% interest rate. By investing in the long term debt fund you are getting = 10.5% - 6.5% = 4% extra returns. At the same time evaluate risk if the unfavourable event plays out (in this case interest rates going down). In that case you will get = 6.5% - 5.5% = 1% lower returns. The risk return trade-off is favourable and therefore, you should go ahead with the investment decision.

Conclusion

I have often seen that, many investors think of investing as shooting darts; some darts may hit the target while others may not. However, if you understand how different financial securities / instruments work, then you make informed decisions based on your needs and situation. The learning goals of our this 3 part series were to help investors understand how different debt funds work, the risk factors involved and how to make informed investment decisions. This series is by no means an exhaustive repository of debt fund knowledge, but hopefully, after internalizing the different concepts discussed in this series and applying them in making investment decisions, you will get better results from your fixed income investments.