Debt as the word suggests is nothing but a loan. But to whom are these loans given? The loans are given to the government, businesses and financial institutions. Why does the government need to borrow? Whenever the expenses incurred by the government exceed the revenue collected, it needs to borrow and for that purpose bonds and treasury bills are issued. Businesses borrow for expansion purposes by issuing corporate bonds and commercial papers, while financial institutions borrow by issuing certificate of deposit or debentures. This explains debt mutual funds in simple terms. But in technical terms a debt mutual fund is one in which major holdings are fixed income investments. There is a wide range of debt mutual funds available based on the time horizon and risk taking capacity like:
Dynamic Bond fund which will invest across the spectrum in the debt markets based on where opportunities arise. It has the flexibility to move between short term instruments like Commercial Papers to long term instruments like Corporate Bonds. The fund manager will evaluate all the segments depending on the interest rate outlook and make the moves accordingly.
Credit opportunity funds also known as CROP funds are debt funds that invest in investment grade debt securities with a lower than AAA rating. They are suitable for investors who take in credit risk for a better return.
Debt Income funds are the debt funds that invest in fixed income securities like bonds and treasury bills. Gilt funds, Monthly income plans, liquid funds and fixed maturity plans are some of the investment options in debt funds.
This explains what kind of instruments do different debt funds invest in. Now let us get familiar with other concepts that go alongside debt mutual funds.
AVERAGE MATURITY PERIOD AND MODIFIED DURATION
Average maturity is the weighted average of maturity for all the bonds in the portfolio. It indicates the extent of interest rate risk in portfolio.
Modified duration on the other hand is the measure of the price sensitivity of the portfolio to change in interest rates. This takes into account funds duration and also its yield to maturity that keeps changing every day. Higher the modified duration more sensitive is your debt fund and ensure that your time horizon is about the same as it’s modified duration.
There is another concept known as Macaulay Duration which establishes a relation between average maturity period and modified duration. When the interest rates rise, the price of any bonds that we hold is going to fall. So, then the question arises is there meter we can use to evaluate a bond and see how sensitive it’s going to be and luckily we have a tool called Macaulay Duration that will perform just that function. It is measured in years. Macaulay Duration is the weighted average maturity of the cash flows from a bond. So if we want to look at a bond from investor’s perspective we can use Macaulay Duration and judge by looking at the bond the time it is going to take us to receive the cash flows so we can compare the duration in terms of years for different bonds, and a bond with a higher number of years for Macaulay Duration is going to be more sensitive to interest rate changes. That means the volatility of the bonds price is going to be higher with respect to changes in the interest rate. It is calculated using the formula:
Where, t = respective time period
C= periodic coupon payment
Y= periodic yield
n= total number of periods
M= maturity value
ACCRUAL AND DURATION STRATEGY OF DEBT FUNDS
In duration strategy, funds aim to make money by predicting interest rate movements. To achieve this, it will buy and sell securities to have a particular maturity date of the folio.
In accrual strategy, intent is to buy those companies where the fund manager expects credit ratings to improve which will hopefully lead to rise in its prices and benefit the fund.
Making a choice among the two depends upon the risk taking capacity of the investor and the returns. In duration strategy, funds take into account the interest rate. In case they expect a fall in interest rate, they tend to buy longer dated bonds and earn profits. In accrual strategy, funds stick to short and medium term tenure irrespective of the interest rates. Credit rating is another deciding factor in choosing one over the other. Another important fact is that the first time investor would always prefer a safer bet and go for duration strategy. Regular income becomes another aspect to lay the decision for choosing among the two. Here, accrual funds win over duration funds as they aim to capitalize on interest income that they earn while duration funds capitalize on events that unfold over a shorter time frame.