The Fund-amental Formula
Last year’s unanticipated cash-squeezing demonetisation, coupled with steadily falling interest rates on traditional savings tools such as fixed deposits, has sparked off renewed levels of interest in debt-oriented mutual funds. According to a recently released report by the RBI, debt funds witnessed net inflows of Rs 2.13 trillion (2.13 lakh crore) in 2016-17. A year ago, this figure stood at a relatively paltry sum of Rs 30,000 crore; seven times lesser. This trend of ‘financialisation’ of household savings is likely to continue, going forward.
As an investor, it is critically important for you to acquaint yourself with some of the important aspects of debt funds – and one of the most relevant portfolio characteristics of any debt fund is its ‘modified duration’.
The relevance of a fund’s modified duration is best understood in conjunction with the knowledge that debt fund NAVs generally move in inverse correlation with underlying interest rates in the economy. For instance, if the RBI were to effect further rate cuts to the tune of 0.5 per cent or 50 basis points in the coming year, this would be good news for debt funds, as their NAVs would rise as a result. The reverse applies too: if interest rates were to be raised unexpectedly by the RBI, debt funds would be dealt a body blow.
Naturally, the question that arises from the above is this: do interest rate movements affect all debt funds to the exact same degree? Not really. This would depend upon – you guessed it – its ‘modified duration’.
Modified duration is an extension of the “Macaulay Duration” of a bond – named after it’s propounder, Canadian economist Frederick Macaulay. The formula for modified duration takes a number of the current metrics associated with your debt fund’s portfolio into
account, churning out a convenient composite number that allows you to estimate the degree of interest rate sensitivity that it is likely to exhibit. The number itself is directly proportional to the time left to a bond’s maturity, and inversely proportional to the size of its coupon. The higher the modified duration of a debt fund, the more volatile it would be. Those invested into funds with higher modified durations need to brace themselves for a relatively bumpy ride!
Put simply, the modified duration of a fund can be used to predict its NAV impact from a one per cent change in underlying interest rates. For instance, if a fund has a modified duration of five years, and underlying interest rates were to fall by one per cent in the next 12 months, its NAV would rise by five per cent!
How should investors interpret modified duration data and use it to make investment decisions? It’s simple. Your choice of debt fund should be driven by two factors – your view on interest rates, and your individual risk tolerance. If you are risk averse or newly migrating from the safe haven of fixed deposits, shy away from funds with higher modified durations, despite their potential to deliver higher capital gains in a falling interest rate scenario. Or, if you are a risk taker, and surmise that interest rates are peaking out and are due for a fall, go for debt funds that have higher modified durations. Don’t fall for the myth that debt funds are risk free – annualised returns from high duration funds have oscillated wildly between -15 per cent and +25 per cent in the past!
