Fund Primer.

M.V.S. Santosh Kumar

Reading and interpreting the fact-sheet of a debt mutual fund can be an arduous task by itself. We try to explain a few key terms that investors would do well to know while reading a debt fund fact-sheet.

Average maturity: This the average holding period of all the instruments held in a portfolio. This measure is calculated as the remaining period for which each instrument is to be held before it falls due.

Each instrument is given weights according to the sums invested in them. Average maturity of a fund provides an indication as to whether the fund follows a short-term or long-term strategy.

A low average maturity is typically resorted to when interest rates are moving up. That's because shorter-term instruments suffer a lower fall during such phases than longer-term ones. Once interest rates are on a declining phase, many funds go for instruments with longer maturity.

A short-term fund may, for instance, hold long-term debentures but this does not mean it holds the instrument for the long term. The fund may have entered such instruments in the secondary market at a time when the residual maturity is not too high.

Modified Duration: Modified duration measures how sensitive the fund's portfolio is to changes in interest rates. The price of a bond and yield on the bond are inversely related. When interest rates decline, bond prices rally, and vice-versa. Modified duration captures the extent of price changes for a given change in the interest rates or yield.

If the modified duration of a portfolio with average maturity of five years is four, then for every 1 per cent move in the yield of a five-year bond, the portfolio's value or price moves 4 per cent. Generally, it is prudent to hold longer duration portfolios during a falling interest rate cycle, while cutting down the duration during a rising rate cycle.

Credit rating: A credit rating is an opinion on a company's ability to repay loans given to it — both the interest payout and principal repayment. The higher the credit rating, the lower the chance of default.

Therefore, investors can look at the credit-rating of the instruments in the portfolio and figure out whether the fund is taking risky bets to improve yields or if it is managing reasonable returns by actively churning the portfolio.

Yield to maturity (YTM): This is the annualised return the fund will get if all the instruments are held until the respective maturity (without selling them before they mature). While the coupon rate is the interest receivable on the face value of each bond, the YTM is based on the current market price of each bond (or fund).

It is the return calculated on the current market price of the bonds in the fund, using the interest receipts (coupon rate) and maturity amount as inflows.

For investments at face value, YTM will be equivalent to the coupon rate. In products such as Fixed Maturity Plans, the YTM of the instruments in which the fund invests provide a broad indication of the returns that can be expected from the fund.

However, in other cases, where the fund may sell bonds before maturity, the YTM is not necessarily the return an investor gets on his fund.

(This article was published in the Business Line print edition dated November 14, 2010)
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