By Niranjan Avasthi
It is nicely recognized that optimal portfolio diversification can aid you create compelling danger-adjusted returns, that is, mitigate downside danger when sustaining the upside prospective of the portfolio. Generally, we gravitate towards debt investments to give our portfolio protection and towards equity investment to create compelling extended-term returns. However, it is significant to fully grasp that when equities are a riskier asset class, debt investments also have particular degrees of danger. Knowing and understanding some of the important dangers in debt investments can aid you far better leverage the rewards of this asset class and select the correct debt fund for your portfolio.
Interest prices as a important danger
Interest prices have an influence on the value of a bond and therefore, are a important danger for debt investments. Interest prices have an inverse connection with bond rates, that is when interest prices rise bond rates fall and when interest prices fall, bond rates rise. However, why does this occur?
Assume you invested Rs one hundred in a 2-year bond which pays an interest of 10% per annum. After a year of holding the bond, the interest prices in the economy rise to 11%.
Now the bond which you hold has 1 year remaining to mature and pays 10% interest. But a new bond in the industry with 1-year maturity now pays 11% interest as prices have risen. This tends to make your bond much less beneficial. If you want to sell this bond in the industry then you will have to compensate the purchaser by supplying a discount of 1% (this is an assumption to reflect the 1% transform in prices – the discount could differ). Hence, you will now have to sell it for much less than Rs 99.
As a outcome of an boost in interest prices, the value of the bond that you have been holding fell.
In the identical instance, assume that the interest prices fell by 1%. Now the bond that you are holding becomes more beneficial than the bond in the industry due to the fact the interest price on this bond is larger than the prevailing interest price in the industry. Now, when you want to sell this bond, you will demand a premium of 1% (this is an assumption to reflect the 1% transform in prices – the discount could differ) for the additional interest that it offers. Hence, you will sell it for Rs. 101.
As a outcome of a reduce in interest prices, the value of the bond that you have been holding rose.
Impact of maturity on bond rates
The demand and provide at a particular interest price is one aspect that impacts the value of a bond. The other aspect is the maturity or the holding period of the bond. Generally, the longer the maturity of the bond, the bigger will be the transform in value due to interest price alterations.
Assume you invested Rs one hundred in a 5-year bond that pays 10% interest. After 1 year, the interest price rises by 1%. To compensate the purchaser for the remaining 4 years, i.e., for 1% loss each and every year, you will have to have to sell your bond at Rs. 96.
In the earlier instance, exactly where the bond’s remaining maturity was 1-year and the price went up by 1%, you sold the bond at Rs. 99. In the second instance, exactly where the bond’s remaining maturity was 4-years and the price went up by 1%, you had to sell the bond at 96.
Due to the uncertainty that persists more than a longer holding period, the longer maturity bond witnessed a larger value transform. Due to the danger linked with holding the bond for a longer time period, the seller demands to provide a larger discount or provide more compensation.
Choosing the correct debt mutual fund
The NAV of a debt mutual fund responds to these alterations. To arrive at a fair worth of the bond, the mutual fund calculates its value each day soon after taking into account such alterations in interest prices. As a outcome, the NAV gets impacted each day.
The calculations accomplished above are rough estimations. However, they can be calculated by employing Modified Duration. This measures how sensitive the value of a bond is to alterations in interest prices.
Understanding modified duration: A modified duration of 5 years signifies that a 1.5% transform in the interest price or yield will influence bond value by 7.5% (1.5 x 5). Higher maturity bonds will have the larger modified duration and as a result, will witness larger volatility due to alterations in interest prices.
How to use modified duration when picking a debt mutual fund?
Your investment time period and potential to absorb volatility is straight connected to modified duration. If you want to invest for 3 months and do not want volatility in returns, you will be far better off investing in a debt fund with a modified duration of 3 months rather than 3 years. The modified duration can be located in the factsheet of the fund.
This is mainly because, if you invest in a fund with a 3-month modified duration, even if interest prices go up by 1%, your returns will not fluctuate considerably. However, if you invest in a fund possessing 3 years modified duration, then a 1% rise in interest price can minimize the NAV by 3%.
How do you handle this uncertainty when investing in a debt fund?
There are 2 strategies to handle this danger.
- Match your investment horizon with the modified duration of the fund: For instance, if you are investing for 1year then invest in a fund with a modified duration of much less than 1 year. This will minimize volatility in the returns due to alterations in interest price.
- Invest in target maturity funds: These funds have distinct maturity like 3 years, 5 years or 10 years. They invest in bonds of the identical maturity and hold them till they mature. Since the bonds in the portfolio are held till maturity, the danger is substantially mitigated. Whether interest prices go up or down, till the time you do not sell the bond, it will not influence your returns (as you do not have to sell at a discount). Similarly, if you keep invested in a target maturity debt fund till its maturity, your returns can be equivalent to what they have been when you invested in the fund (yield at the time of investment). While the NAV might intermittently fluctuate, no loss or gains are realised due to the fact the bond is held till maturity. You can basically pick a fund with a target maturity that suits your demands and keep invested till its maturity. This reduces the influence of interest price alterations on your returns.
Niranjan Avasthi is the Head – Product & Marketing, Edelweiss Asset Management Limited (EAML) and the views expressed above are his personal. Please seek advice from your economic advisor just before investing.