With interest rates on the downturn, there are no dearth of suggestions on which debt fund to invest in. Before you act on them, it would do you good to understand these concepts regarding interest rates and its impact on a fund's portfolio.

1. 3 must-know concepts about debt funds
With interest rates on the downturn, there are no dearth of suggestions on which debt fund to
invest in. Before you act on them, it would do you good to understand these concepts regarding
interest rates and its impact on a fund's portfolio.
Author : iFast Content Team
The recent policy easing by the central bank and the lower-than-expected inflation numbers
have triggered a host of investment recommendations in the relevant debt funds.
With regards to the changing interest rate scenario, there are three terms that investors must
understand.
 Yield to Maturity (YTM)
YTM of a debt fund portfolio is the rate of return an investor could expect if all the
securities/bonds in the portfolio are held until maturity. For instance, if an income fund has a
YTM of 10%, it means that if the portfolio remains the same until all the holdings mature, then
the return to the investor would be 10%.
However, the YTM does not remain constant as the portfolios are actively managed by the fund
manager.
Yield is different from the coupon rate. Let’s say a bond has a face value of Rs 100 with an 8%
coupon rate. This means that the investor will earn Rs 8 per annum for every Rs 100 invested.
Now let’s say interest rates in the economy rise to 10%.
However, the Rs 8 per annum is fixed. So to increase the yield to 10%, the price of the bond will
have to drop to Rs 80. Similarly, the reverse will take place when interest rates fall. If interest
rates fall to 6%, the price of the bond will go up to Rs 133.
This is how the yield fluctuates to changes in the interest rate of the economy. And, this is how
the price of the bond moves inversely to interest rates.
Why it is important:
YTM broadly indicates to the investor the kind of returns that could be expected. But it is not a
definite indicator since returns may vary due mark-to-market valuations or changes in the
portfolio.
 Weighted Average Maturity (WAM)
This is more commonly referred to as the average maturity of a debt fund. It is the average time
it takes for securities in the portfolio to mature, weighted in proportion to the amount invested.
Eg:
Rs 1,000 invested in Bond A matures in 5 years
Rs 2,000 invested in Bond B matures in 10 years
Total investment in debt portfolio = Rs 3,000
WAM = (1000/3000)*5 + (1000/3000)*10 = 8.33 years
Why it is important:
Average maturity indicates the sensitivity of the fund portfolio to interest rate changes. The
higher the average maturity the greater is the volatility of returns in the fund. This is seen in

2. debt funds with longer investment horizons, such as income funds (eg: Canara Robeco Income:
8.05 years) and gilt funds (eg: ICICI Prudential Gilt Fund Investment Plan: 10.81 years). On the
other hand, average maturities in liquid funds have been restricted to 90 days while ultra short-
term funds could go higher but are usually less than a year, making them less volatile to interest
rate movements.
The average maturity of a scheme gives you a broad guideline in terms of finding a debt fund
suitable for the time horizon of your investment.
 Modified Duration (MD)
As mentioned above, bond prices and interest rates are inversely related. This means, if there is
a rise in interest rates then there is a fall in the price of the bond. If there is a fall in interest
rates, then the price of bond will rise. MD is the change in the value a bond or debt security in
response to the change in interest rates. So let’s say the MD of the bond is 4.23. This means that
the price of the bond will increase to 4.23 with a 1% (100 basis point) increase in interest rates.
Basically, MD provides a good indication of a bond’s sensitivity to a change in interest rates. The
higher the duration, the more volatility the bond exhibits with a 1% change in interest rates.
The MD of a portfolio will take into account all the instruments. So naturally it would change
every time there is a change in the composition of the portfolio.
Why it is important:
By and large, it is a more accurate measure of sensitivity of the portfolio than average maturity.
Low duration funds like liquid and ultra short-term are less volatile. However, longer duration
funds like income and gilt are likely to perform better in a falling interest rate scenario because
of the capital appreciation in the portfolio. For instance, the growth plans of the following
schemes from the same fund house all have different MDs: Birla Sun Life Ultra Short Term Fund
(0.72), Birla Sun Life Short Term (1.22), and Birla Sun Life Income Plus (5.67).
How to use this information
All these above terms can be seen in the factsheets published by the asset management
companies on each of their individual funds. On a more advisory note, while investments and
redemptions in liquid and ultra short-term funds can be done anytime, it would require
expertise and insight to get the timing right in investments in longer duration funds, which are
subject to volatility and negative returns in the interim. Take advice from your financial planner
if you are unsure of your move and would like to capitalize on interest rate movements.
Also read: How to make an ultra short-term fund work for you
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