Equity mutual funds (MFs) are quite popular with investors, and so are the terms associated with this product category. However, things are different when it comes to debt MFs. Here, we attempt to simplify certain terms relating to debt MFs that are found in factsheets and explain how one can use them for fund selection.

Yield to maturity

Yield to maturity (YTM) indicates a potential return that one can generate through investing in debt funds. Typically, YTM is associated with a bond and it is calculated by incorporating periodic coupon which you receive regularly, the price at which you purchased bond and the face value of bond — amount you can get at maturity. Simply put, YTM is the potential return which you can get on a bond provided it is held till maturity. Note YTM can be different at different point in time on account of factors such as change in interest rates and credit rating.

As a debt MF invests in multiple bonds, the portfolio YTM is the weighted average yield of all such bonds held by the fund. Unlike a fixed deposit, there is a good possibility that you won’t get returns as same as YTM from an open-ended debt fund on account of portfolio churning by the fund manager. However, if one wants to attain returns closer to YTM, one can go for target maturity funds and some closed-ended funds such as fixed maturity plans and interval funds.

Also, the YTM that you find in a debt MF factsheet is a gross YTM that has to be adjusted with expense ratio to get net YTM. Do note that YTM shouldn’t be looked as a sole indicator for making investment decisions, as abnormally-high YTM can also be due to holding low-quality instruments, high credit and liquidity risk.  

Maturity, duration

While maturity and duration might appear similar terms and, in fact, both are measured in years, their interpretations are very different. Maturity is quite straightforward, as it is the residual tenure left for a bond before it pays principal. For debt fund, maturity is calculated on a weighted average basis.

Typically, long-duration funds, medium-to-long duration funds and gilt funds have higher average maturity than liquid funds and other short-term debt funds. For instance, average maturity for a Quant Liquid Fund is around 31 days, while that for ABSL Long Duration Fund is 5.91 years. Though generally, the funds with higher maturity have higher sensitivity to interest rate changes, the sensitivity part is better depicted with the help of duration. For dynamic bond funds, average maturity might change as per the interest rate cycle prevalent.

In a debt MF factsheet, you can find two types of duration – Macaulay duration and Modified duration. Macaulay duration is a measure of how long the bonds in the debt fund will take to repay the principal from the internal cash flows (coupon payments and principal repayment) generated from the debt funds. It is calculated by dividing the time-weighted present value of all cash flows with normal present value of all cashflows.

So, if you want to eliminate the interest-rate risk, you can map your investment horizon to the Macaulay duration of a fund having roll-down strategy, wherein the fund manager attempts to hold bonds till maturity. Nippon India Dynamic Bond Fund, Axis Dynamic Bond Fund and Target Maturity Funds are some funds following this strategy.

Some argue that Modified duration (MD) is a truer measure of a debt fund portfolio’s sensitivity to the change in interest rates. MD is calculated by dividing Macaulay Duration with the YTM of the fund. For instance, ABSL Long Duration bond has a MD of 6.77 years, which means that one per cent increase in the interest rate can potentially reduce the NAV of the fund by 6.77 per cent and vice-versa.

Hence, higher the MD, higher the sensitivity. Higher sensitivity is not always bad as in the falling interest rate scenario, high MD helps funds generate higher returns. MD helps in understanding a fund manager’s strategy and view on interest rates. If the MD of a fund is higher than its usual MD, the fund manager might have anticipated fall in interest rates and vice-versa.

Further, you can also apply the same while making your investment decision. If you don’t want to have an interest rate risk in your portfolio, you can go for funds having lower MD, while if you want to make gains through interest rate movements that involve extra risk, you can go for funds with higher MD.

Debt fund selection
Don’t look at a particular metric in isolation while making an investing decision
Things to look at
Yield to maturity
Average maturity