Long term debt funds such as gilt or income are most vulnerable to the interest rate movement. A recent action by RBI on the interest rates followed by the sudden fall in the returns of debt funds has also seen long term gilt funds getting the highest beating among all categories. Even within this category there were some which were impacted most while some had a lesser impact. In such situations, for a layman investor, selecting a debt fund becomes a difficult task considering the lack of knowledge on the market itself.
A measure like Modified Duration, when used with other parameters, helps in analyzing the impact of interest rates on debt mutual funds schemes. This tool is mentioned in the factsheet across debt schemes and by understanding it one can simplify the task of selecting debt funds for their requirement.
Let see what it is and how does it help investors in creating a sound debt portfolio-
What is Duration?
To understand modified duration we need to understand Duration first. Generally, bond prices moves inversely to the interest rates i.e. if interest rates moves down, the prices goes up and if rates move up they go down. Thus, bond prices are very sensitive to any movement in the interest rates. To know the amount of sensitivity Duration is used. This is measured in years and is named as Macaulay Duration. In simple words, Macaulay Duration of the bond tells you how long it will take the price of the bond to repay the internal cash flows. This concept is used only for the bonds where there are fixed cash flows.
What is Modified Duration?
A Modified Duration is an extended version of Macaulay Duration. It is also measured in years and tells you the sensitivity of the fixed income security with 1% change in interest rates. It is calculated by the below formula
% Change in Value of Security= Modified Duration*1% change in interest rates
So if modified duration is 10 yrs and the interest rate moves up by 1% then the price of the security will move down by approx. 10%. Similarly if the interest rate moves down by 1% the price of the security will move up by approx. 10%. Thus, modified duration will give estimates of sensitivity of the bond or a portfolio towards every 1% movement in interest rates.
What you can Analyze?
When the sensitivity of any bond/fund is analyzed using duration, it tells you the risk associated with it. A modified duration goes a bit deeper and will tell you the % change in the fund movement with every 1% change in the interest rates. So a fund with high duration will be more sensitive to the interest rate movement then a lower duration fund. For investors, by comparing the different debt mutual funds scheme within a category, they can analyze which has more interest rate risk. There are also categories like dynamic bond funds where there are frequent changes in the portfolio. These funds rely more on fund manager skills. The modified duration analysis can also indicate how the fund manager is taking a view on the movement of interest rates. But no investment decision should rest on this analysis alone.
Thus, by using this measure investors can analyze and compare different debt mutual funds scheme to see which matches their objective of the investment. If one is looking to invest for a shorter period, taking a higher risk will not be in the list of parameters and so low duration funds will find a place in the portfolio. On other hand if one has a higher risk appetite and a longer investment horizon, the preference for taking an extra risk for higher returns will be there which can be met by including higher duration fund in the portfolio.
But do remember that this is not the only factor which can impact a portfolio of a debt scheme. Credit quality of the securities and other factors are there which are equally important and so should be given equal weightage when you are comparing schemes to create a debt portfolio.
- Jitendra P.S.Solanki
The author is the CFP & Founder of JS Financial Advisors