Understanding Interest Rate Risk in Debt Mutual Funds

Published: April 21, 2015 at 9:39 am

Last Updated on

There are two ways in which an investment in a debt mutual fund grows: (1) by buying bonds with high coupon rates  and holding them until maturity. The growth in this case is by accrual of  interest. (2) by choosing long-term bonds issued by the government and aim for capital gains when the bond price increases due to decrease in interest rates.

Higher the coupon rate, lower the credit rating. Therefore the accrual strategy is subject to risk of default. Most investors do not recognize  that the accrual strategy is also subject to interest rate risk. That is, the value of the high coupon rate bonds can also change value depending on interest rate movements.

If the fund manager buys only government bonds  (long or short-term), there is no risk of default and only risk of capital loss due to increase in interest rates.

When interest rates increase, new bonds will have a higher coupon rate than existing ones. Since the demand for existing bonds decreases, they will have to be priced lower in order to be sold in the bond market. In fact the price has to drop to ensure the yields matches that of the new bonds.

Similarly if interest rates decrease, new bonds will have a lower coupon rate than existing ones. The demand for the old bonds increases and so does the price until the yields match.

Yield

Yield is a measure of the interest income generated by a bond.

Yield =  coupon amount / bond price.

If a bond is priced at 100 with a coupon rate of 10%, the coupon amount is 10% of 100 = 10

The initial yield  = 10/100 = 10%

For debt funds, the weighted average of portfolio bond yields is calculated. This is known as running yield or yield to maturity.

It is the expected yield if the bonds in the folio are held to maturity. 

Modified Duration

There is a simple metric which the investor can use to understand how sensitive a debt mutual fund is to interest rate changes: the modified duration.

The modified duration is measured in years and gives us two pieces of information:

  1. For 1% change in interest rates, what would be the expected increase or decrease in fund NAV. A modified duration of 2 years implies, a possible NAV change of 2% for 1% change in interest rate. So longer the modified duration, higher the interest rate sensitivity.
  2. For a given yield to maturity, how long would the fund take to recover, if there is a loss due to increase in interest rates.

Change in bond price = -1 x Modified Duration x (change in interest rate)

For debt funds, the formula is

Change in NAV = -1 x Modified Duration x (change in interest rate)

If the modified duration is 4 years and if the interest rates have increased by 1%,

change in interest is +1% (it would be -1% if the rates had dropped by 1%)

So the change in bond price or NAV =(-1) x 4 x (+1%) = -4%

The –1 is included in the formula to show that interest rate movement and bond price or NAV movement  are opposite to each other.

Higher the modified duration, higher would the gain or loss due to rate movements.

Suppose the current annual yield to maturity of the debt fund (net of expenses) is 10% per year. This means that each day the NAV will increase by

10%/365 = 0.03% each day.

If the interest rate has increased by 1% in a day, a debt fund with a modified duration of 4 years would suffer a NAV loss of 4%.

The fund NAV will continue to increase 0.03% a day. To recover from the change in interest rate, the fund will take

4%/0.03%  = 133 days or about 4.5 months.

Thus modified duration gives you an idea of how much you stand to lose or gain when the rates change and along with the current yield to maturity of the fund, it gives you an idea of how long the fund would take to recover from a rate hike.

Here are some numbers for a few funds in each debt fund category listed by VR online.

The time to recover here is in response to a 1% increase in interest rates.

Debt mutual fund modified duration

Note that that values can vary widely within a category. Would be a good idea to always choose a fund with low modified duration and reasonable yield to maturity. High yield to maturity implies the fund is invested low rated bonds. So tread with caution.

When it comes to debt fund selection, the modified duration is the most important metric that I would look at.

Here is a something I wrote about an year ago:

How to Select Debt Mutual Funds Suitable For Your Financial Goals?

References:

Do share if you found this useful
Share your thoughts on this topic at the  Reddit freefincal_user_forum

Reach your financial goals like a pro! Join our 1600+ Facebook Group on Portfolio Management! You can now reduce fear, doubt and uncertainty while investing for your financial goals! Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community. The 1st lecture is free!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!) or you buy the new Tactical Buy/Sell timing tool!
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. Follow us on Google News Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only 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, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
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 low cost! Get it or gift it to a young earner

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, 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 199 (instant download)
Free android apps