debt fund are not risk free. They are also subject to volatility due to credit and duration risk. Duration risk represents the effect of interest rate fluctuations on the value of assets held by the fund. Duration risk is also called interest rate risk and acquires greater importance in rising interest rate scenarios.
In the attached table, we display the year-to-date (YTD) returns of some of these Fund with long maturity.
If you had invested in any of these schemes at the beginning of the year, your return on investment would be negative if they are redeemed now. This does not mean that the funds have performed poorly; In fact, most of these funds are outperforming the benchmark. This is to highlight how investments in debt funds can get affected if the duration is not taken into account.
Bond prices fluctuate
Bond prices are inversely related to interest rates. When interest rates in the economy rise, bond prices fall and vice versa.
When debt funds have a higher average maturity, the investment will be subject to higher volatility. By choosing a fund that has maturity close to your investment horizon, you can minimize the impact of volatility on redemptions.
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Shriram said, “While there are no standard rules, the general understanding is that if a debt fund holds its average maturity, they can expect an estimated yield (YTM- Yield to Maturity), which is the same at the time of investment. prevalent,” said Sriram. BKR, Senior Investment Strategist at Geojit Financial Services.
This effect of interest rate fluctuations on bond prices can also be assessed with a metric called ‘modified duration’.
For example, when the revised period is five years, this means that for every 1% increase in the interest rate, bond prices will fall by 5% and vice versa.
“In case of debt funds like fixed maturity plans and target maturity funds, “you will see that the revised tenure of these funds gets reduced as we get closer to the maturity date,” said Joydeep Sen, an independent debt market analyst. If held till maturity, the effect of interest rate movement on your holdings will eventually be zero.
How to choose?
It is important to know the tenure of debt funds and how this period will be managed before investing.
“Some funds manage the duration dynamically while some manage it passively. “To generate alpha on market returns, an investor would need to invest in actively managed funds,” said Sahil Kapoor, Senior Executive Vice President, IIFL Wealth.
In the case of a risk-averse investor, “it would be better to match the investment horizon to the duration of a passively managed fund such as a target maturity fund to ensure less variability in expectation of returns over the investment horizon,” Kapoor said. ,
The classification of debt funds by SEBI also makes it easier for investors to select funds based on tenure. Referring to this, Abhijit Bhave, CEO, Fisdom Private Wealth, said, “Liquid funds are ideal for short-term investment goals of up to 3 or 6 months, whereas ultra-short debt funds can suffice for an investment horizon of 6 months. 1. 1 year. One can invest in short term debt funds if the investment tenure is between 1 to 3 years, whereas dynamic/medium term bond funds on the other hand are better suited for investors with a tenure of 3-5 years “