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

Published: December 7, 2019 at 9:17 am

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:

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₹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.

Do share this article with your friends using the buttons below.

🔥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!
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.

  • 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 with 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!

Explore the site! Search among our 2000+ articles for information and insight!

About The Author

Pattabiraman editor freefincalDr. 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, 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 what 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 you 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!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl version covers of Chinchu gets a superpower.
Most investor problems can be traced to a lack of informed decision-making. We have all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it and teach him several key ideas of decision-making and money management is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
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!
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 & it's 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
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished 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 Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis 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

Travel-Training-Kit-Cover-new This is an in-depth dive analysis 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)