4 Debt Fund Terminologies You Should Know

Contrary to what you may have been led to believe, Debt Funds or Fixed Income 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 some 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 money 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, ultra-short-term debt funds have an average maturity of fewer than 6 months, whereas GILT Funds have an average maturity that’s close to 10 times that! With inflation, risks looming large and the possibilities of a rate hike imminent, investing in a higher maturity debt fund in 2022 may prove an unwise move. 

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 increase rates by 100 bps the next year (a widely anticipated policy normalisation move), the impact on an ultra-short term debt fund would be a negative 0.5 per cent or so, whereas the average GILT fund would take a massive hit of 5 per cent - pretty much offsetting all 90 per cent of coupon payments that the fund would receive from its holdings!  

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 was 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: 

Credit Profiles of debt funds came heavily into focus in 2020 when a leading asset management company wound up its debt funds overnight, in light of dwindling liquidity and redemption pressure during the throes of the pandemic. It’s no surprise that these funds mostly held bonds with “A and below” rated securities.  

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 at all!). Therefore, if a fund holds mostly “A and Below” rated securities, this would indicate that its portfolio has a probability of default that’s somewhere between 0.56 per cent and 2.31 per cent (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 per cent NAV impact on the portfolio (which doesn’t sound too bad) – but in an unforeseen event such as a pandemic, the impact could be far, far worse. Investors should choose funds with lower credit profiles carefully, and with the advice of a qualified Financial Advisor.