Last Updated on December 29, 2021 at 5:14 pm
Whether we hold a diversified equity fund, an aggressive hybrid, multi-asset fund, balanced-advantage fund, arbitrage fund or a debt mutual fund, here are three key mutual fund terms that all retail investors should know.
It is a misconception that only debt mutual funds hold bonds. It is a misconception that only debt mutual funds suffer from credit problems and fluctuate due to interest rate movement. Almost all types of mutual funds hold bonds and therefore, these three key bond-related mutual terms are applicable to all fund categories.
If you are new to bonds and how mutual funds holding bonds operate, please start with the first part of this article published yesterday, Basics of Debt Mutual Funds Explained for New Investors and then come back here.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! 🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
About the author: Swapnil Kendhe is a SEBI Registered Investment Advisor and part of my list of fee-only financial planners. You can learn more about him and his service via his website Vivektaru. In the recently conducted survey of readers working with fee-only advisers, Swapnil has received excellent feedback from clients: Are clients happy with fee-only financial advisors: Survey Results. As a regular contributor here, he is a familiar name to regular readers. His approach to risk and returns are similar to mine, and I love the fact that he continually pushes himself to become better as you see from his articles.
Past articles by Swapnil:
- Becoming a competent & capable financial advisor: My journey so far
- Are you a conservative investor? Here is how you can grow your money smartly
- SEBI Registered Investment Adviser Application Process: step by step guide
- Looking for a fee-only financial planner? Here is a list of questions to ask before you sign up
- Should Mutual Fund Distributors become SEBI Registered Investment Advisors?
- Everything you need to know about equity portfolio construction
- Build an equity mutual fund portfolio with these simple steps
1 Macaulay Duration
In the first part of this article, we considered two tables illustrating the change in the price of a bond when interest rates increase or decrease by various amounts. In both the tables, we assumed that both interest and principal would be paid at the maturity. In reality, most bonds pay interest semi-annually or annually, and a major portion of a bond’s present value is because of interest payments in the interim. Therefore, maturity, which considers only the timing of repayment of principal on maturity, is an inadequate measure to look at the bond.
Macaulay duration is a measure that takes into consideration the interim interest payments as well. Frederick R. Macaulay who introduced the concept of bond duration argued that, if two bonds have the same maturity, but one pays annual or semi-annual interest payment while other pay interest at maturity, the earlier bond represents a shorter-term loan. Likewise, if two bonds have the same maturity and pay annual or semi-annual interest payment, but one has a higher coupon rate, that bond represents a shorter-term loan. Therefore, that bond would have a shorter duration.
Calculation of Macaulay Duration
If you detest math, you can skip this part.
The Macaulay Duration is a measure of how long it will take for you to recoup your investment in a bond. It is calculated as the weighted average of the lengths of time prior to receipt of interest payments and principal, where each payment’s weight is determined by dividing its present value by the current market value of the bond.
Face value of bond ₹10,000
Coupon rate (interest rate) 8%
Interest payment ₹800
Years to maturity 5
The current market value of bond ₹10,000
Yield to maturity (IRR) 8%
| Years from now (1) | Payment (2) | The present value of payment at 8% (3) | Present Value of Payment as a Percentage of the Bond’s Current Market Value (4) | Column (1) times Column (4) |
| 1 | ₹800 | ₹741 | 0.074 | 0.074 |
| 2 | ₹800 | ₹686 | 0.069 | 0.137 |
| 3 | ₹800 | ₹635 | 0.064 | 0.191 |
| 4 | ₹800 | ₹588 | 0.059 | 0.235 |
| 5 | ₹800 | ₹544 | 0.054 | 0.272 |
| 5 | ₹10,000 | ₹6,806 | 0.681 | 3.403 |
| ₹10,000 | 1.00 | Macaulay Duration = 4.312 |
2 Modified Duration
The Modified duration expresses the percentage change in the price of the bond per unit change in the yield to maturity.
Modified Duration = Macaulay Duration/(1 + current yield to maturity)
(For above mentioned bond, Modified Duration = 4.312/(1+0.08) i.e 3.993)
The modified duration of the debt mutual fund portfolio expresses the percentage change in NAV (Net Asset Value) of the fund for every 1% change in the yield to maturity of the portfolio.
For the debt fund portfolio in the image above, the modified duration is 6.97. This means that if interest rates go up by 1%, the fund’s NAV will come down by 6.97%. If interest rates go up by 2%, the fund’s NAV will come down by 2*6.97, i.e. 13.94%. Similarly, if interest rates come down by 1%, the fund’s NAV will go up by 6.97%.
Higher the Macaulay duration, the higher the modified duration and the higher the interest rate sensitivity of the debt fund.
3 Maturity length of the Bond and Yield
If all the factors remain the same, longer maturity length bonds pay higher interest (or have a higher yield) than shorter maturity bonds of the same credit quality. This is because, as the maturity length of the bond increases, the uncertainty about the timely payment of the bond obligations increases. Interest rates could also move up during the life of the bond. To compensate for this higher uncertainty, longer maturity length bonds offer higher interests.
Occasionally, interest rates on short-term bonds are higher than interest rates on longer-term bonds. When this happens, the yield curve is said to be inverted. Inverted yield curves occur less often than upward sloping curves. There is a tendency over time for inverted or flat yield curves to return to a normal, upward-sloping shape.
How much return would I get from a Debt MF?
Most investors believe that their potential return from a debt mutual fund will be yield to maturity of the fund portfolio minus its expense ratio. It doesn’t work that way.
Yield to maturity (YTM) is an estimate of how much return the debt fund portfolio may earn. Actual return is likely to differ (considerably) from the YTM. This is because YTM is realised only if certain conditions are realised. These conditions are:
- The fund manager holds all bonds in the portfolio until maturity.
- The fund portfolio does not change.
- Interest payment received from bonds is reinvested at the YTM rate.
In reality, none of these conditions holds in debt mutual funds. Fund managers do not necessarily hold bonds until maturity. When bonds are sold before maturity, there could be a capital gain or capital loss if interest rates change in between. Therefore, the earnings from the bond fund portfolio would be different from the quoted YTM. The portfolio also changes continually because investors buy and sell units and because fund managers buy and sell bonds.
The assumption that the interest payments received from the bond fund portfolio shall be invested at the quoted YTM rate is highly unlikely to happen. If interest income is reinvested at a higher rate, the fund will actually earn more than it’s stated YTM. While if the interest income is reinvested at lower rates, the actual return will be less. We can never know what the interest rates will be in the future.
We cannot predict the actual return that an investor shall realise in debt mutual funds in advance. YTM does not predict the return from a debt mutual fund portfolio. The chief usefulness of YTM is to compare different debt funds. It helps us evaluate how much yield we are sacrificing for higher credit quality or how much higher yield we can pick up if we lengthen the average maturity.
When some bonds in the debt mutual fund portfolios are downgraded, the value of these bonds is marked down. The YTM of such funds is significantly higher until such bonds remain in the portfolio. Investors should remember that risk rises along with the yield, and higher yield doesn’t necessarily result in a higher return.
Stay tuned for part 3 and catch up on part 1
1: Basics of Debt Mutual Funds Explained for New Investors
3: Debt Mutual Fund Categories Explained For Retail Investors
If you wish to work with Swapnil, his website is Vivektaru.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)