Debt mutual funds are investment schemes which invest in debt securities that generate a fixed income. They have a predetermined date and pay fixed interest over the tenure of their existence. Hence the returns from debt funds are more predictable and stable than equity funds. The performance of debt funds is affected by interest rate cycles. One of the most important parameters when investing in debt funds is to check their average maturity.
What is Average Maturity?
Debt securities have a fixed tenure and mature at the end of the tenure. At the end of tenure, the bondholder or investor gets back the principal and interest in full. Since debt funds invest in multiple debt securities, it can be difficult to check each security’s maturity. Instead, we can just check its average maturity. You need not calculate the average maturity of a debt fund, it is already available in the factsheet.
Average maturity is the weighted average of all current maturities of the securities in the debt fund. The weight is the percentage holding of each security in the fund. This tells the average time taken for all the securities to mature in the fund.
If the average maturity of a debt fund is three years, this means all securities, on average, will mature in three years. However, if you check each security’s maturity, it might be different from three years.
The average maturity of the fund changes as the securities near the maturity date or if the fund manager churns the portfolio. At the end of the period, the fund doesn’t mature, only the securities in the fund’s portfolio mature.
How to Interpret Average Maturity?
A high average maturity indicates the debt fund has securities which take longer time to mature, while a low average maturity means the underlying securities have a shorter maturity.
Debt funds such as medium to long duration, long duration, and gilt funds have a higher average maturity. In contrast, short-duration, ultra-short, and low-duration funds have shorter average maturity.
Impact of Average Maturity on Debt Mutual Funds
Debt funds invest in bonds and are sensitive to interest rate changes. The bond prices will go up if the interest rates come down, and vice versa. If the market interest rates fall, the bond will become more valuable as it pays a higher interest than the market, so its price will go up. Similarly, if the market interest rates rise, the bond will become less valuable, and its price will go down.
Since debt funds invest in bonds, they are also sensitive to interest rate changes. Looking at a debt fund’s average maturity, one can easily tell how an interest rate change will affect the fund.
A debt fund with longer average maturity is more vulnerable to interest rate changes than a fund with a short maturity. In other words, these funds have a higher interest rate risk. So, a fund with a longer average maturity will be prone to more price fluctuations. In contrast, a fund with a shorter average maturity will be prone to fewer price fluctuations.
By looking at the average maturity, it is easy to interpret the fund manager’s view on interest rates. The fund manager will increase the fund’s average maturity by adding more long-term bonds if he thinks the interest rates will soften in the near term. As a result, if the interest rates fall, there will be capital appreciation. In contrast, if the fund manager thinks the interest rates will go up, he will reduce the average maturity by adding more low-duration bonds to the portfolio.
As an investor, you can look at the fund’s average maturity and portfolio to understand the risk taken by the fund. You can easily compare the fund with its peers before making an investing decision.
What is Macaulay’s Duration?
Apart from average maturity, another parameter that will help evaluate debt funds is Macaulay Duration. The weighted average Macaulay Duration of all securities for a debt fund is considered as Macaulay Duration.
Macaulay Duration measures the time it takes for the bond issuer to repay the principal from the internal cash flows generated by the bond. The Macaulay Duration of the bond directly depends on the time when the securities mature. The longer the time to mature, the longer will be Macaulay Duration.
Macaulay Duration is inversely related to the coupon rate. The higher the coupon rate, the higher the cash flows from the bond, hence Macaulay Duration will be shorter.
What is Modified Duration?
Modified duration is an extension to Macaulay Duration. It measures how much the price of the fund changes due to a change in the interest rate or yield to maturity (YTM). YTM is the potential returns of a debt fund. The higher the YTM, the higher the return, but the underlying portfolio might be of lower quality, indicating a high risk.
Modified duration follows the concept that bond prices and interest rates are inversely related. It tells how much the change in the interest rate will change the value of the fund. In other words, it tells the effect of a 1% change in the interest rate on the price of the fund. For example, if the modified duration is four years, a 1% fall in the interest rate will lead to a 4% increase in the price of the bond.
Difference Between Average Maturity, Macaulay’s Duration and Modified Duration
Average maturity tells the average time taken for all the underlying securities to expire. The longer the average maturity, the higher will the interest rate risk. Average maturity changes only when the fund manager churns the portfolio or the securities are maturing.
In contrast, the Macaulay Duration tells the average lifetime of the bond, considering the stream of future coupon payments. It changes as the price, coupon rate, or yield changes. The higher the coupon rate, the shorter the Macaulay Duration.
Modified duration, on the other hand, measures the bond’s price sensitivity with respect to interest rate changes. It is a measure of risk by estimating how much the price of the bond can fluctuate due to a change in interest rate. Modified duration increases as maturity increases, and coupon and interest rate decreases.