Three Key Mutual Fund Terms All Retail Investors Should Know

Whether you hold equity-oriented mutual funds or debt-oriented mutual funds, here are three key mutual fund terms all retail investors should know. This is part two of a three-part series by SEBI RIA Swapnil Kendhe

Three Key Mutual Fund Terms All Retail Investors Should Know

Published: December 7, 2019 at 9:17 am

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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.

 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:

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%

 

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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₹7410.0740.074
2₹800₹6860.0690.137
3₹800₹6350.0640.191
4₹800₹5880.0590.235
5₹800₹5440.0540.272
5₹10,000₹6,8060.6813.403
₹10,0001.00Macaulay 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.

Example of a modified duration for a debt fund
Example of a modified duration for a debt fund. Screenshot courtesy ValueResearch

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?

Example of a yield to maturity of a debt fund
Example of a yield to maturity of a debt fund. Screenshot courtesy ValueResearch

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:

  1. The fund manager holds all bonds in the portfolio until maturity.
  2. The fund portfolio does not change.
  3. 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.

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2 Comments

  1. Hello Sir,

    The mobile version of articles, in which there are tables, the final columns have a background of black and text is not audible. However, desktop version has no problems. I have noticed the same in previous articles, but thought that as a one-time issue. Requesting to have a look, so that need not change to desktop mode for viewing tables.

    Thanks
    Subramanian

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