A thread on Debt mutual fund basics
Let's understand why and how debt mutual fund NAV react to changes in interest rates and how to select a right debt fund and manage interest rate risk.
Share widely if you find this useful.
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Let's understand why and how debt mutual fund NAV react to changes in interest rates and how to select a right debt fund and manage interest rate risk.
Share widely if you find this useful.
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Relation between bond price and interest rates.
Bond price fall when interest rates rise and vice-versa.
But why? Let's understand.
Say you invest Rs. 100 in a bond of 2 years which pays an interest of 10% per annum.
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Bond price fall when interest rates rise and vice-versa.
But why? Let's understand.
Say you invest Rs. 100 in a bond of 2 years which pays an interest of 10% per annum.
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After 1 year, interest rates in the economy rise to 11% since RBI increased interest rates.
Now the bond which you hold has 1 year remaining to mature and pays 10% interest. But a new bond in the market with 1 year maturity now pays 11% interest as rates have risen.
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Now the bond which you hold has 1 year remaining to mature and pays 10% interest. But a new bond in the market with 1 year maturity now pays 11% interest as rates have risen.
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If you want to now sell your bond in the market. At what price will you sell it?
Your bond worth Rs. 100 pays 10% interest, new bond in market pays 11%. Hence, you need to compensate the buyer of your bond for 1% loss in interest in next 1 year.
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Your bond worth Rs. 100 pays 10% interest, new bond in market pays 11%. Hence, you need to compensate the buyer of your bond for 1% loss in interest in next 1 year.
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You can compensate the buyer by selling your bond at Rs. 99 instead of 100.
This will get buyer Rs. 11 after 1 year. Rs. 10 from interest plus Rs. 1 additional on maturity (he bought bond worth 100 for 99 and on maturity he will get paid 100)
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This will get buyer Rs. 11 after 1 year. Rs. 10 from interest plus Rs. 1 additional on maturity (he bought bond worth 100 for 99 and on maturity he will get paid 100)
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What happened here..
-Interest rates went up by 1% and old bond which was paying lesser interest than market rate was sold at a lower price than its original value to compensate the buyer.
- in nut shell, interest rate went up, bond price fell.
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-Interest rates went up by 1% and old bond which was paying lesser interest than market rate was sold at a lower price than its original value to compensate the buyer.
- in nut shell, interest rate went up, bond price fell.
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In the same example if interest rates fell by 1%.
Then u will sell ur bond at premium for 101. The buyer will get 9% returns. (He bought bond worth 100 for 101 and on maturity he will get paid 100+10 rs interest)
Note - These are rough calculations to simplify concept.
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Then u will sell ur bond at premium for 101. The buyer will get 9% returns. (He bought bond worth 100 for 101 and on maturity he will get paid 100+10 rs interest)
Note - These are rough calculations to simplify concept.
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Now the 2nd most important concept to understand is..
- longer the maturity of the bond, larger will be the change in price due to interest rate changes.
Let's understand this using the same example.
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- longer the maturity of the bond, larger will be the change in price due to interest rate changes.
Let's understand this using the same example.
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Now you invest Rs. 100 in a 5 year bond which pays 10% interest.
Interest rates rise by 1% after 1 year.
To compensate the buyer for remaining 4 years for 1% loss each year, you will need to sell your bond at Rs. 96.
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Interest rates rise by 1% after 1 year.
To compensate the buyer for remaining 4 years for 1% loss each year, you will need to sell your bond at Rs. 96.
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In earlier example where bond's remaining maturity was 1 yr and rate went up by 1% you sold the bond at 99.
In second example where bond's remaining maturity was 4 yrs and rate went up by 1%, you had to sell the bond at 96.
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In second example where bond's remaining maturity was 4 yrs and rate went up by 1%, you had to sell the bond at 96.
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What happened here...
Longer maturity bond witnessed higher price change. This is because the seller needs to compensate more (due to longer period) to the buyer.
Imagine how much a10 year bond after1% rise in rates will need to be discounted. It will be huge.
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Longer maturity bond witnessed higher price change. This is because the seller needs to compensate more (due to longer period) to the buyer.
Imagine how much a10 year bond after1% rise in rates will need to be discounted. It will be huge.
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A debt mutual fund investing in bonds, has to value its portfolio on daily basis to arrive at NAV.
To arrive at fair value of the bond, the mutual fund calculates its price everyday after taking into account such changes in interest rates.
This impacts the NAV daily.
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To arrive at fair value of the bond, the mutual fund calculates its price everyday after taking into account such changes in interest rates.
This impacts the NAV daily.
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In above examples we did back of the envelope calculations, but the actual change in bond's price due to given amount of change in interest rate can be calculated using Modified Duration.
M. Duration allows us to measure the sensitivity of a bond price to changes in rates.
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M. Duration allows us to measure the sensitivity of a bond price to changes in rates.
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A M.Duration of 5 years means 1.5% change in Interest rate or yield will impact bond price by 7.5%. (1.5x5)
Higher maturity bond will have higher modified duration and therefore, higher volatility due to changes in interest rates.
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Higher maturity bond will have higher modified duration and therefore, higher volatility due to changes in interest rates.
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M.duration calculates the weighted average time before the bond would receive the bond's cash flows.
In nut shell it let's you know in how much period you get your investments back from the bond.
(Will do another thread to explain this very important concept)
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In nut shell it let's you know in how much period you get your investments back from the bond.
(Will do another thread to explain this very important concept)
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How to use M.Duration while selecting a debt mutual fund?
If you want to invest for 3 months and don't want volatility in returns. Will you invest in a debt fund with duration of 3 months or 3 years?
Let's decode..
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If you want to invest for 3 months and don't want volatility in returns. Will you invest in a debt fund with duration of 3 months or 3 years?
Let's decode..
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If you invest in a fund with 3 month m.duration, even if interest rates go up by 1%, your returns will not fluctuate much.
But if you invest in a fund having 3 yrs M.Duration, then 1% rise in interest rate can reduce the NAV by 3%
(M.Duration can be found in factsheet)
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But if you invest in a fund having 3 yrs M.Duration, then 1% rise in interest rate can reduce the NAV by 3%
(M.Duration can be found in factsheet)
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Can you afford your returns to fluctuate by 3% in 3 months period that you are investing for?
Very unlikely.
How do you manage this uncertainty while investing in a debt fund?
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Very unlikely.
How do you manage this uncertainty while investing in a debt fund?
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There are 2 ways to manage
1. Match your investment horizon with the m.duration of the fund.
For instance, if you are investing for 1yr then invest in a fund with m.duration of less than 1 yr.
This will reduce volatility in the returns due to changes in interest rate
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1. Match your investment horizon with the m.duration of the fund.
For instance, if you are investing for 1yr then invest in a fund with m.duration of less than 1 yr.
This will reduce volatility in the returns due to changes in interest rate
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2. Invest in target maturity funds.
These funds have specific maturity like 3yrs, 5yrs or 10 yrs. They invest in bonds of same maturity and hold them till they mature.
You can select a fund with maturity that suits your need and stay invested till its maturity.
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These funds have specific maturity like 3yrs, 5yrs or 10 yrs. They invest in bonds of same maturity and hold them till they mature.
You can select a fund with maturity that suits your need and stay invested till its maturity.
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This reduces the impact of interest rate changes on your returns.
These funds are like holding a bond till its maturity. Even if interest rates go up or down, till the time you don't sell it, it will not impact your returns. (As you don't have to sell it at discount)
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These funds are like holding a bond till its maturity. Even if interest rates go up or down, till the time you don't sell it, it will not impact your returns. (As you don't have to sell it at discount)
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Same way if you stay invested in a target maturity debt fund till its maturity, your returns can be similar to what they were when you invested (yield at the time of investment)
The NAV may fluctuate in between, but if u hold it till maturity your returns will be stable.
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The NAV may fluctuate in between, but if u hold it till maturity your returns will be stable.
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BHARAT Bond ETFs were the first ever target maturity debt funds launched in India
You can study details of these funds here bharatbond.in
Globally, iBonds by BlackRock are very popular target maturity funds.
ishares.com/us/strategies/…
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You can study details of these funds here bharatbond.in
Globally, iBonds by BlackRock are very popular target maturity funds.
ishares.com/us/strategies/…
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Remember these points when you invest in debt funds next time.
Interest rate risk is very important consideration today as we may see a reversal of rate cycle in coming time.
Check M.Duration of the fund, calculate the risk and then invest in an informed way.
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Interest rate risk is very important consideration today as we may see a reversal of rate cycle in coming time.
Check M.Duration of the fund, calculate the risk and then invest in an informed way.
24/end**
This is the latest target maturity debt index fund from @EdelweissMF
https://twitter.com/iRadhikaGupta/status/1365590711928721411?s=19
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