Liquid and ultra-short-term debt funds tend to have lower average maturity (AM) than income and gilt funds. Longer the AM, higher is the ‘interest rate sensitivity’ of the fund
By Ashwin Patni
Building a diversified portfolio is the hallmark of a good investor. This means having exposure to multiple asset classes, including equity and debt. The latter is especially important, as it helps to tide over the volatility which equities bring. While equity funds are susceptible to market fluctuations, debt funds are low-risk and provide steady returns by investing in instruments including bonds, government securities and commercial papers.
However, investors often find it difficult to choose the right debt fund for their portfolio. For their convenience, every mutual fund releases a monthly factsheet which provides a holistic picture of the fund’s objective, performance and portfolio. But this information can come across as complicated jargons unless an investor knows how to interpret it. So here’s a look at the seven key parameters mentioned in a debt fund factsheet and how you can use it to find the right fund for your portfolio.
A debt fund has exposure to multiple debt instruments, including commercial papers (CPs), certificate of deposits (CDs), NCD’s, bonds and gilts. The date of maturity of each of these investments is likely to vary. That is why, a debt fund factsheet provides the Average Maturity (AM) of the fund. This refers to the average time taken for all debt securities in the portfolio to mature. Liquid and ultra-short-term debt funds tend to have lower AM than income and gilt funds. Dynamic funds have the ability to change the AM based on the evolving interest rate scenario. The longer the AM, the higher is the ‘interest rate sensitivity’ of the fund.
This ‘interest rate sensitivity’ of a fund and its impact on a scheme’s net asset value is indicated by Modified Duration (MD). It might be noted that interest rates and bond prices are inversely proportional, i.e., when interest rates go up, bond prices fall and vice versa. So debt funds with longer MD will face greater movement in NAV as compared to debt funds with shorter MD. Based on your risk appetite and investment objective, you can choose a debt fund with lower or higher interest rate sensitivity.
Yield to maturity
Yield to Maturity (YTM) is one of the indicators of potential returns a fund can generate for the investor. YTM is determined by two things. One is the duration of the fund: longer duration funds tend to have higher YTM. Second is the credit quality of bonds that the scheme invests in: lower rated securities offer higher yields as compared to higher rated securities. Higher YTM means likelihood of higher returns and risk.
As an investor, you are likely to wonder when you will be able to recover the principle amount you invest. The answer to this can be found from the Macaulay Duration of a debt fund. It reflects how long it will take for the ‘principle’ of a bond to be repaid from the internal cash flows (earnings from interest and repayments) generated by the bond. Funds with longer Macaulay will take longer to recover principle invested.
Check how the fund has allocated investment between various debt instruments, including commercial papers, certificate of deposits, treasury bills, gilts, non-convertible debentures, corporate bonds and government bonds. You should then compare if the allocation is in line with the objective of the scheme. It also helps in gauging the concentration of risk in the portfolio.
Additionally, a debt fund’s holdings are categorised based on credit ratings – AAA, AA+, A1+ – given by ratings agencies. AAA signifies lower credit risk and higher quality and is well-suited for conservative investors. On the other hand, lower rated debt papers are high on risk as well as likely yields. It is better to opt for a fund which has a larger share of higher quality bonds. Also, while companies rely on external rating agencies, availability of a robust internal research team also augurs well for the fund and the fund manager.
Performance vis-à-vis benchmark
Debt funds’ performance is also measured against a benchmark index. This helps you see how the fund has performed vis-à-vis its benchmark since inception.
An understanding of these components and its implication on your investment will help you choose the right debt fund. Remember to factor in both your risk appetite as well as financial goals and accordingly make an informed decision.
The writer is head, Products & Alternatives, Axis AMC