What the Best Two Most Important Parameters While Selecting Debt Fund Pros Do (and You Should Too)

 

If you are looking to invest in a mutual fund for a short term goal which is less than 5 years away, what kind of debt fund would you choose? The simple answer to the above question is to follow our recommendations and you are done. But to be fully confident about your selection of fund it is better that you know what the 2 most important criteria is when it comes to selecting debt schemes.

 

Two important parameters for choosing the right category of debt funds are – AVERAGE MATURITY & MODIFIED DURATION

 

1. AVERAGE MATURITY

 

The average maturity of a debt mutual fund indicates the tenure or the time to maturity of all the assets held by the mutual fund. A debt mutual fund invests in various fixed income instruments such as government bonds, corporate papers, CDs, etc. each of these instruments has its own maturity date.

 

The average maturity does not indicate when the scheme matures. Open-ended schemes do not mature.

 

Higher the average maturity of the portfolio, greater would be the interest rate risk. The NAV of the portfolio with the higher average maturity will fluctuate more in case of sharp movement in interest rate than those with the lower average maturity.

 

2. MODIFIED DURATION

 

The modified time span (not to be confused with maturity) is the measure of price sensitivity of the fund to change in interest rates. Funds with a prolonged reform duration would be more sensitive to a given change in interest rates. For example, a bond/fund with a reform duration of 4.9 years can be expected to undergo a 4.9% change in price for each 1% movement in interest rates.

Higher the average maturity higher would be the reform duration!

Higher the reform duration higher would be the interest rate risk!

 

Funds with the higher duration tend to give a higher return in a falling interest rate scenario, but in case of rising interest rate scenario, it can generate a negative return.

 

So it is always better to create your portfolio with the schemes that suit the interest rate cycle keeping in mind the reform duration of the fund.