The after-effects of de-monetisation coupled with continuous drop in interest rates on traditional savings instruments like fixed deposits has triggered renewed interest in debt oriented / gilt long-term mutual funds. As per the recent report released by Reserve Bank of India (RBI), debt funds in general witnessed net inflow of Rs 2.13 lakh crore during 2016-17. The figure for the previous year was just Rs 30,000 crore. However, long-term debt funds are most vulnerable to interest rate movements. Let us discuss below how to use modified duration to pick debt oriented funds.
Interest rate sensitivity
Any action on the interest rates by RBI leads to sudden fall or increase in returns of debt funds (NAVs). For instance, if RBI goes for interest rate cuts to the extent of 50 basis points or 0.5% in the forthcoming year, this would be good news for debt funds as their NAVs would rise and vice versa. So, debt fund NAVs generally move inversely with underlying interest rates in the economy.
Sensitivity is not same across funds
Obviously, the next question is whether interest rate movement affects all debts funds with the same magnitude? Within this category of debt funds there were some funds which were impacted most while some had a lesser impact. In such situations, selecting a debt fund becomes a difficult task for investors. Here comes the concept of modified duration in picking debt funds.
To understand modified duration, we need to understand duration first. We know that bond prices are very sensitive to any movement in interest rates. Duration is used to measure the amount of sensitivity. This is measured in years and is named as Macaulay Duration (named after Frederick Macaulay, a Canadian economist). Basically, Macaulay duration of the bond indicates how long it will take the price of the bond to repay the internal cash flows. This concept is used only for bonds where there are fixed cash flows.
Modified duration is an extended version of Macaulay Duration. It is again measured in years and signals the interest rate sensitivity of the fixed income security with reference to changes in interest rates. For instance, if a fund has a modified duration of five years and underlying interest rates to fall by one per cent in the next one year, its NAV would rise by 5%.
How to use modified duration?
If you are risk averse or just planning to shift your investments from fixed deposits, shy away from funds with higher modified duration, inspite of their potential to deliver higher capital gains in an interest rate falling scenario. Contrary to the above, if you are a risk taker and anticipate interest rates to fall, choose debt funds that have higher modified duration. Modified durations are mentioned in the factsheet across debt schemes.
Debt funds are not risk free
A popular myth among investors is that debt funds are risk free which is not true. Past data shows that annualised returns from high duration bonds ranges very widely, from -15% to 25%. To conclude, modified duration, when used with other parameters such as the credit quality of the securities and other factors, helps in analysing the impact of interest rate sensitivity and helps you to choose the right debt funds for your investment portfolio.
The writer is professor of finance & accounting, IIM Shillong