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A debt fund is a mutual fund that invests in fixed income securities such as government bonds, corporate bonds, treasury bills, money market instruments etc. These are typically investments that offer capital appreciation and provide regular interest. Debt funds might be known as bond funds or fixed income funds. The main benefits of investing in debt funds are the low cost of investing, stable returns, capital protection to some extent and higher liquidity in case of government bond funds.

Debt funds are preferred by investors who are risk averse and are looking for regular income. This is because these funds are less volatile when compared to equity funds. These funds provide better returns than bank fixed deposits and savings accounts most of the times. There are many different debt funds such as gilt funds, liquid funds etc. The most important point to note while zeroing in on debt funds is their duration. This shouldn’t be confused with maturity.

What’s the difference between maturity and duration?

Maturity of a fixed income security is the amount of time that remains until the principal is paid back. So, a 10-year bond or debt security earns interest for ten years from the date it is purchased. So, the maturity of this investment will be ten years. At the end of 10 years, the principal is paid back to the investor and there will be no more interest payments. The maturity of a fixed income security is fixed and doesn’t change. There is no maturity for a debt fund as it holds a number of securities and keeps trading in those securities.

Now, coming to duration. You must know that bond prices move inversely to the interest rates, that is, if interest rates move up, they go down. So, bond prices change when interest rates change. Duration is used to understand how sensitive a debt security is to interest rate changes. Duration is measured in years. Longer the duration, more is the interest rate risk. So, longer duration debt funds are riskier than shorter duration debt funds.

Duration is especially useful when you want to compare different types of funds that hold a variety of securities with different maturities. Since duration is measured in years, it is easy to compare different debt funds and select a debt fund that is in line with your risk-taking capacity. If a debt-oriented fund has a higher duration, the more is the likelihood that the fund’s price would fall if the interest rates rise.

Modified duration might be better

Most mutual fund analysts believe that modified duration should be used when you are looking at debt funds. Modified duration is an extended version of duration. It shows the sensitivity of the debt security for every 1% change in interest rates. It is calculated using the formula –
Modified duration = Duration / 1 + (yield-to-maturity / number of coupon periods per year). This measure will tell you the percentage change in the fund’s price movement with every 1% change in the interest rates.

So, the modified duration is a risk measure that can be used by bond investors to measure how much the price of a bond could rise with a decline in interest rates. For instance, if interest rate moves up by 1% and the modified duration is 10 years, then the price of the fund will move down by 10%. If the interest rate moves down by 1%, the fund’s price will move up by 10%. Funds with higher duration will be more sensitive to interest rate movements.

Modified duration helps investors analyze the impact of interest rates on debt mutual fund schemes. By comparing different debt funds, investors can understand the associated interest rate risks. You don’t need to calculate modified duration. The value is mentioned in the factsheet across debt schemes.  If you are looking to invest for a shorter period, low duration funds will be right for your portfolio. On other hand if you have a higher risk appetite and a longer investment horizon, you can get higher returns with a higher duration fund in the portfolio.

Where are interest rates going?

As of now, interest rates don’t seem to be going up. As per data from Trading Economics, India’s interest rates are projected to be around 3.5% in 2021. Interest rates might stay low for the next few years. Given the scenario, short and medium duration debt funds might be good options. Long-duration debt funds have an average duration of more than 36 months. Individuals with a low-risk appetite should stay away from long duration debt funds. Medium duration funds invest in debt securities having maturity of three years. Note that medium duration funds have a higher duration than liquid funds, ultra-short duration funds, low duration funds, and short duration funds. Investors should select debt funds that are right for their financial goals.

Top funds across duration and maturity

Tags: Debt Funds, Duration Funds, Long Duration Debt Funds, Medium Duration Debt Funds, Mutual Funds