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UnderstandingInterestRateRiskin
DebtMutualFunds
byfreefincal

Therearetwowaysinwhichaninvestmentinadebtmutualfundgrows:(1)
bybuyingbondswithhighcouponratesandholdingthemuntilmaturity.
Thegrowthinthiscaseisbyaccrualofinterest.(2)bychoosinglongterm
bondsissuedbythegovernmentandaimforcapitalgainswhenthebond
priceincreasesduetodecreaseininterestrates.
Higherthecouponrate,lowerthecreditrating.Thereforetheaccrualstrategy
issubjecttoriskofdefault.Mostinvestorsdonotrecognizethattheaccrual
strategyisalsosubjecttointerestraterisk.Thatis,thevalueofthehigh
couponratebondscanalsochangevaluedependingoninterestrate
movements.
Ifthefundmanagerbuysonlygovernmentbonds(longorshortterm),there
isnoriskofdefaultandonlyriskofcapitallossduetoincreaseininterest
rates.
Wheninterestratesincrease,newbondswillhaveahighercouponratethan
existingones.Sincethedemandforexistingbondsdecreases,theywillhave
tobepricedlowerinordertobesoldinthebondmarket.Infactthepricehas
todroptoensuretheyieldsmatchesthatofthenewbonds.

Similarlyifinterestratesdecrease,newbondswillhavealowercouponrate
thanexistingones.Thedemandfortheoldbondsincreasesandsodoesthe
priceuntiltheyieldsmatch.
Yield
Yieldisameasureoftheinterestincomegeneratedbyabond.
Yield=couponamount/bondprice.
Ifabondispricedat100withacouponrateof10%,thecouponamountis
10%of100=10
Theinitialyield=10/100=10%
Fordebtfunds,theweightedaverageofportfoliobondyieldsiscalculated.
Thisisknownasrunningyieldoryieldtomaturity.
Itistheexpectedyieldifthebondsinthefolioareheldtomaturity.
ModifiedDuration
Thereisasimplemetricwhichtheinvestorcanusetounderstandhow
sensitiveadebtmutualfundistointerestratechanges:themodified
duration.
Themodifieddurationismeasuredinyearsandgivesustwopiecesof
information:
1. For1%changeininterestrates,whatwouldbetheexpectedincreaseor
decreaseinfundNAV.Amodifieddurationof2yearsimplies,apossible
NAVchangeof2%for1%changeininterestrate.Solongerthemodified
duration,highertheinterestratesensitivity.
2. Foragivenyieldtomaturity,howlongwouldthefundtaketorecover,if
thereisalossduetoincreaseininterestrates.
Changeinbondprice=1xModifiedDurationx(changeininterestrate)
Fordebtfunds,theformulais

ChangeinNAV=1xModifiedDurationx(changeininterestrate)
Ifthemodifieddurationis4yearsandiftheinterestrateshaveincreasedby
1%,
changeininterestis+1%(itwouldbe1%iftherateshaddroppedby1%)
SothechangeinbondpriceorNAV=(1)x4x(+1%)=4%
The1isincludedintheformulatoshowthatinterestratemovementand
bondpriceorNAVmovementareoppositetoeachother.
Higherthemodifiedduration,higherwouldthegainorlossduetorate
movements.
Supposethecurrentannualyieldtomaturityofthedebtfund(netof
expenses)is10%peryear.ThismeansthateachdaytheNAVwillincreaseby
10%/365=0.03%eachday.
Iftheinterestratehasincreasedby1%inaday,adebtfundwithamodified
durationof4yearswouldsufferaNAVlossof4%.
ThefundNAVwillcontinuetoincrease0.03%aday.Torecoverfromthe
changeininterestrate,thefundwilltake
4%/0.03%=133daysorabout4.5months.
Thusmodifieddurationgivesyouanideaofhowmuchyoustandtoloseor
gainwhentherateschangeandalongwiththecurrentyieldtomaturityofthe
fund,itgivesyouanideaofhowlongthefundwouldtaketorecoverfroma
ratehike.
Herearesomenumbersforafewfundsineachdebtfundcategorylistedby
VRonline.
Thetimetorecoverhereisinresponsetoa1%increaseininterestrates.

Notethatthatvaluescanvarywidelywithinacategory.Wouldbeagoodidea
toalwayschooseafundwithlowmodifieddurationandreasonableyieldto
maturity.Highyieldtomaturityimpliesthefundisinvestedlowratedbonds.
Sotreadwithcaution.
Whenitcomestodebtfundselection,themodifieddurationisthemost
importantmetricthatIwouldlookat.
HereisasomethingIwroteaboutanyearago:
HowtoSelectDebtMutualFundsSuitableForYourFinancial
Goals?
References:
1.DurationDebtConcepts

Thankyouforreading.Youmayalsolike
UnderstandingCreditRatingRiskinDebtMutualFundsAugust29,
2015
HowtoSelectDebtMutualFundsSuitableForYourFinancialApril17,
2014
DebtMutualFunds:Riskvs.RewardAugust22,2014
Ifyouthefoundarticle/calculatoruseful,pleasespareamomenttoshareit:
6KDUH



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ThisentrywaspostedinDebtMutualFunds.

HowtoChooseaLiquidMutualFu

MoneyCantBuyHappiness.OrCani

5commentsonUnderstandingInterestRateRiskin
DebtMutualFunds
RaghuRamamurthysays:
April21,2015at4:29am

Verygoodinput.IhaveinvestedinGiltFunds.
Reply

Bharanisays:
April21,2015at1:54pm

Goodinformation.Ihave2comments:
1.Highyieldtomaturityimpliesthefundisinvestedlowratedbonds.Sotreadwith
caution.
Ithinkthisisnotalwaystruelongtermgsecs(sovereignrating)hashighYTMandhigh
modifiedduration,sosensitivityishigh.Nottomentioninterestrateriskthough
2.Inabsoluteterms,with1%leadingto2%diffinNAVisgood.ButifIwanttoapplythis
directlyintodaysmarket,Iwontbe,sincemostinc/decinNAVoccurinanticipationof
futureratedec/inc!Andwhenithappensinstepsoveraperiodoftime,difficulttocorrelate,
say,anactualratedecwiththeNAVincreasesalreadyhappened!
PleasecorrectmeifIamwrong.
Reply

PattabiramanMurarisays:
April21,2015at1:37pm

Thankyousir.
Reply

Karthikeyansays:
April22,2015at10:28am

Sir,thankyouforexplainingthisconceptclearly,Ireadaboutmodifieddurationinan
academiccourse,butreadingitheregavemesomesenseofhowitcanappliedintheworld
ofdebtmutualfunds.
Imnotsureifitsidealtoalwayschooseafundwithlowmodifiedduration,wouldntahigh
MDservebetterinascenariowhereinterestratesarecomingdown?Isitbettertodiversify
onesdebtportfoliowithinvestmentsinbothcategories?
Reply

Nithinsays:
May10,2015at2:49pm

IfyouseeFranklinIndiaUltraShortBondFundSuperInstitutionalPlaninvalue
research,on10/05/2015theNAVchangeisshownas0.01%.ButtheYTMis9.75%and
9.75%/365=0.026%(perday).Thenwhyisitdisplayed0.01%?AmImissingsomething?
Reply

Thankyouforreading.Yourthoughtsare
vitaltothehealthofthisblog.Pleasesparea
momenttoletmeknowwhatyouthink.
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