4 Debt Fund Terminologies Every Investor Should Know

Contrary to popular belief, or to what your Adviser may have told you for that matter, Debt Funds are not "just like Fixed Deposits". Regardless of whether you're venturing into the world of debt fund investing for the first time, or you're a seasoned debt fund investor, here are 4 terminologies you should be aware of.

Average Maturity
The Average Maturity of a debt fund is an important parameter to consider before making an investment decision. This figure is calculated by taking the weighted average of the times remaining to maturity for all the constituent bonds that a fund holds in its portfolio. As the average maturity of a debt fund increases, so does its sensitivity to changes in interest rates. As a thumb rule, it's better to park short term moneys into debt funds with shorter average maturities, and vice versa. Average maturities can differ greatly, depending upon the type of debt fund in question. For instance, Birla Sun Life Cash Manager Fund (an "ultra-short term" debt fund) has an average maturity of less than 1 year as on date, whereas SBI Magnum Gilt Fund - Long Term Plan has an average maturity that's close to 11 years!

Modified Duration
Modified Duration is closely linked to Average Maturity, in the sense that the Modified Duration of debt funds with higher maturity portfolios will be higher, and vice versa. Modified Duration is derived from the "Macaulay Duration" of a bond, which essentially signals the time in years it takes for a bond investor to recoup its true cost, depending upon its current market price. Simply put, the Modified Duration of a bond indicates its sensitivity to interest rate changes. As a thumb rule, the price impact of a rate cut/ increase on the price of a bond will be +/- modified duration times the quantum of the rate cut/ increase. For instance, if the RBI were to reduce rates by 25 bps during its August policy meet (a widely anticipated move), the NAV of Birla Sun Life Cash Manager Fund would likely go up by just about 0.25%, whereas the NAV of SBI Magnum GILT Fund - Long Term Plan would go up by as much as 2.75%. The result would be reversed if the RBI were to spring a surprise and increase rates by 25 bps.

Yield to Maturity
The Yield to Maturity or "YTM" of a debt fund indicates the annualised returns that the fund would earn if it were to hold all of its currently held bonds till their maturity dates - and none of them were to default. This is a hypothetical figure, of course, because the fund manager is likely to chop and change the portfolio specifics depending upon the credit or interest rate outlook he or she holds. Obviously, a higher overall YTM indicates a potentially higher NAV contribution from the bond coupons themselves. However - there are no free lunches in the investment world! To achieve a higher YTM, fund managers need to necessarily take on a higher degree of credit risk. Bonds that are highly secure will command a lower YTM than bonds with a higher probability of default (the cost of the incremental risk gets priced into the bond's yield). For this reason, YTM cannot be viewed in isolation as a fund selection criterion. It needs to be considered in conjunction with the Credit Profile of the fund in question.

Credit Profile
Bonds are assigned ratings by official rating agencies such as CRISIL and ICRA, and their ratings generally indicate their probability of default. AAA indicates a near zero risk of default, whereas a C rating for a 1-year residual maturity bond indicates that there's roughly a 1-in-5-chance of default (those aren't great odds!). Take the example of Franklin India Low Duration Fund, which has a relatively high YTM of 8.84% and an average maturity of 1.61 years. The fund has managed to achieve this relatively high YTM by holding roughly 40% of its portfolio into "A and below" rated securities. Per CRISIL data, this would indicate that 40% of its portfolio has a probability of default that's somewhere between 0.56% and 2.31% (the last published default rates for 1 and 2-year A rated bonds, respectively). Statistically speaking, this additional risk could lead to a negative 1% NAV impact on the portfolio. Investors should choose funds with lower credit profiles carefully, and with the advice of a qualified Financial Advisor.