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Right now, we are in a falling interest rate scenario. If your financial planners, advisors and wealth managers, and bank relationship managers have not yet recommended debt mutual funds to you, they certainly will do so now.
When investing in debt mutual funds, there are some parameters to be considered and compared before you finalize which fund to invest in, based on your risk appetite, tax bracket, time horizon and liquidity requirements / investment time horizon.
But since most investors don't know what these parameters are, or have heard of them but don't understand them, the questions go un-asked and therefore un-answered.
Before we go into the details, first lets lay some groundwork.
From the beginning of this article, you have drawn the conclusion that a falling interest rate scenario is good for debt mutual funds, which hold bonds in their portfolios. Why is this so?
Because Interest rates and bond prices share an inverse relationship. When interest rates in the economy move down, such as right now, prices of bonds issued at the earlier rate (i.e. higher than the new rate) go up as they are more valuable to own because they give a higher interest rate than the new available bonds.
For example: A few months ago a fund manager bought a bond issued at its face value of Rs. 100 which pays interest at 9% p.a. for 5 years. Now, if the rate of interest for a fresh series of bonds with the similar maturity and risk profile earns 8.25% due to a fall in the interest rate, then the bond which the fund manager bought a few months ago will gain value and now will trade at a price above its face value i.e. above Rs. 100. It's price will go up, as interest rates go down.
So we have now understand that bond prices and interest rates are inversely related, which is why in a falling interest rate scenario, bond prices will go up, so debt mutual funds which hold these bonds in their portfolios will gain value, so you as an investor holding the now-more-valuable debt mutual funds will make more money on your investment.
But, back to our original question, how do we decide which debt funds to own? What are the parameters we need to check and compare?
Let's see what the main parameters are:
Yield
Yield denotes the rate of return on your bond investment. It takes into consideration income accrued by way of interest only. This means it does not consider any capital gain on the bond in the secondary market.
There are different ways of calculating yield on bonds.
Current Yield
As you know, bonds can be bought at par (at their face value), at premium (by paying more than their face value) or at discount (by paying less than the face value). Even so, the coupon rate (rate agreed to be paid throughout the life of the bond by the issuer) remains the same for you, no matter whether you are buying the bond at par, at premium or at a discount, but a noteworthy point is that the yield though will differ.
For example, say a fund manager bought a bond with a face value of Rs. 100 at par with a coupon rate of 10% p.a. current yield will be 10%. But the same would drop to 9.80% if he would have bought it at Rs. 102. Similarly, if he would have purchased a bond at a discount of Rs. 2 to the face value - i.e. at Rs. 98, then the current yield on the bond would have moved up to 10.20%.
Yield to Maturity (YTM)
YTM is nothing but the anticipated rate measuring the time adjusted total returns that one will make on a bond as an investor, if he holds the bond till maturity. YTM takes into account the current market price, the face value, the interest payment that will fall due on the bond and years left in its maturity. This calculation of the returns is based on several assumptions which are:
- Coupon payments will be made on time, and will be reinvested at the same rate
- The bond is held till its maturity
Example: A 5 year bond with an annual coupon rate of 10%, paying semi-annually and bought at Rs. 95 (Face value 100) exactly at the completion of 1 year will have YTM of 11.94%. Similarly, when the same bond is priced and bought at Rs. 105, at the completion of one year, the YTM will be 8.68%.
Another conclusion that can be drawn from YTM...
If YTM > Coupon it means the Bond is trading at a discount
If YTM = Coupon it means the Bond is trading at par
If YTM < Coupon it means the Bond is trading at a premium
Duration
In finance, duration has a specific connotation. It measures (in number of years) the time taken by all expected future cash flows of the bond to repay the time adjusted true value of the bond.
Factors affecting the Duration
- Number of years left in the maturity of the bond
- Coupon Rate and yields
- Credit Ratings
Duration of bonds bearing high coupons and lower maturities would be lower as higher coupons would take lesser time to equate the time adjusted true value of the bond. Duration of a bond is an useful measure as bonds with higher durations witness high price volatility than bonds with lower durations.
For example: A bond bearing an annual coupon rate of 10% and the yield of 10% maturing after 3 years would have a duration of 2.73 years. On the other hand, bond with an annual coupon and the yield of 9% having tenure of 5 years would have duration of 4.24 years. However, credit rating plays a crucial role in determining the duration; as bond with lower rating would usually quote higher coupon thereby realising the true time adjusted value of a bond faster.
A bond with higher duration is more sensitive to the interest rate movement. As maturity nears even a longer term bond would become less vulnerable to the interest rate risk.
Modified duration
A varied form of duration, measures the effect of each percentage change in yield on the duration. It measures the effect that each percentage change in interest rates will have on the price of the bond.
We have already seen that the bond with a coupon and the yield of 9% having tenure of 5 years would have duration of 4.24 years. Assuming the bond is trading at par and pays interest on an annual basis, the YTM will be equal to the coupon rate of 9%. Now, for a percentage increase in YTM; the duration of the bond will decline to 3.89 years. In simple terms, the bond price will decrease by 3.89% with a one percentage increase in interest rate and vice-versa.
Average Maturity
The average maturity of the portfolio determines the time involved in maturing of all the debt assets in the portfolio of the debt mutual fund. Higher the average maturity of the portfolio greater would be the interest rate risk on the portfolio of the debt mutual fund.
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