Debt funds aren’t risk-free. They are also subject to volatility due to credit and duration risk. Duration risk represents the impact of interest rate movements on the value of assets held by the fund. Duration risk is also called interest rate risk and gains more significance in the rising interest rate scenario.
In the accompanying table, we display the year-to-date (YTD) returns of some of the funds with longer maturity.
Had you invested in any of these schemes at the beginning of the year, the returns on your investments would be negative if they were to be redeemed now. This is not to say that the funds have performed badly; in fact, most of these funds have been performing better than the benchmark. This is to highlight how the investments in debt funds can get impacted if the duration is not taken into consideration.
Bond prices fluctuate
Bond prices have an inverse relationship with interest rates. When the interest rates in the economy go up, the bond prices fall and vice-versa.
When the average maturity of a debt fund is higher, the investments will be subject to higher volatility. By selecting a fund that has a maturity close to your investment horizon, you can lower the impact of volatility on redemption.
This impact of the movement of interest rate on bond prices can also be gauged by a metric called ‘modified duration’.
For example, when the modified duration is five years, that means, for every 1% rise in interest rate, the bond prices will fall by 5% and vice versa.
In the case of debt funds with defined maturity such as fixed maturity plans and target maturity funds, “you will see that the modified duration of these funds comes down as you approach the maturity date," said Joydeep Sen, an independent debt market analyst. The impact of interest rate movement on your holdings will eventually be nil if held till maturity.
How to choose?
It is important to know the duration of the debt fund and how the duration will be managed before investing.
“A few funds manage duration dynamically while a few manage it passively. To generate alpha over the market returns, an investor will need to invest in funds that are actively managed," said Sahil Kapoor, senior executive vice-president, IIFL Wealth.
In the case of a risk-averse investor, “he/she would be better off matching the investment horizon to the duration of a passively managed fund such as target maturity funds to ensure low variability in return expectation over the investment horizon," added Kapoor.
Sebi’s categorization of the debt funds also makes it easier for investors to select funds based on duration.