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Debt Mutual Funds for Beginners Part 2 | Use YTM & Modified Duration to Improve Returns & Lower Risk - YouTube
Channel: ET Money
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hi everyone my name is shankar nath and
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welcome to video 2 of eti money's debt
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mutual fund series
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in the first video we focused on the
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building blocks what is the bond how are
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bonds price the different types of debt
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mutual funds
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and more importantly how to look at
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these funds on the basis
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of their investment objective investing
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strategy credit risk interest rate risk
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and some other important variables
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in the second video of the series we
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shall center our attention on the fact
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sheet
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over the next 20 odd minutes we learn
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the meaning of terms like
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yield to maturity modified duration
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average maturity etc with examples
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and how you can apply these learnings in
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improving your investing process
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and if there are any particular parts of
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the video that you really like
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do let us know in the comments box below
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as it will help us create more follow-up
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content
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across our blogs and other social media
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channels
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subtitles let's get started
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[Music]
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the fact sheet should highly be the
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starting point before you invest
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in any debt mutual fund all et money
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users
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and hopefully you are one can access the
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contents of the fact sheet in the scheme
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detail page of every fund the fact sheet
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is generally a summary but provides a
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wealth of information
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and if used properly it does help
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improve the investors returns while
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reducing the portfolio risk
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now let's understand the different parts
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of a debt fund fact sheet with an
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example
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so we have one here for the icici
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prudential banking and psu debt fund
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most fact sheets can be divided into six
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main sections
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the performance section the fun details
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the quantitative indicators
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the portfolio the style box and the risk
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ometer
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now most investors are already using the
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fund performance fund details and the
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style box in their fund selection
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criteria
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so we want to address these in this
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video instead we'll focus on the three
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ignored sections which are the
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quantitative indicators
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the portfolio and the risk ometer with
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that being said
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let's start with the first of the four
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quantitative indicators which is
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the yield to maturity
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[Music]
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debt mutual funds do not offer a fixed
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rate of return like plant deposits
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instead debt funds offer an indicative
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return called the yield to maturity
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a bonds yield to maturity is the total
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rate of return an investor expects to
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earn
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if he or she holds the bond until its
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maturity
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let's understand this with an example so
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we have a bond whose face value is 1 000
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rupees and offers an annual coupon rate
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of 6 percent
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the bond itself has 10 more years to
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mature and is currently available at a
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discount so let's say the bond is priced
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at
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900 rupees now we apply the ytm formula
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so the annual interest is 60 rupees the
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face value is 1000 rupees the current
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price of the bond is 900 rupees
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and there are 10 years still left for
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maturity this gives us a ytm
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of 7.4 percent now this 7.4
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is the ytm for a single bond but debt
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mutual funds
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invest in many bonds and thus the
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portfolio yield
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will be the weighted average yield of
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all such bonds held by the fund
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now one point i said earlier was that
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the ytm is merely
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an indicator of portfolio returns in
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fact there is every possibility that the
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ytm
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and the actual returns would never match
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in an open-ended debt fund
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let's understand this by extending our
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previous example to another scenario
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in this instance we assume that two
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years have passed and in that period the
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company which issued the bond
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has gone through some difficult market
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conditions and as a result the bond has
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had
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a ratings downgrade which has resulted
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in a sharp fall in its price
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and is now trading at 600 rupees in this
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case when we apply our ytm formula one
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finds that the new ytm will be much
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higher
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at 13.8 percent so bond which was at a
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ytm
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of 7.4 percent two years back is now at
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a ytm of 13.8
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this means the ytm is constantly
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changing with changes in rating
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with interest rate changes inflation and
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many other variables
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and that's probably why we believe that
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the ytm may not be the best or maybe
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not the only indicator that one should
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use to determine debt fund returns
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another related point is that an
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abnormally high ytm like the 13.8
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percent we saw in our example
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can be indicative of investments in low
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quality debt instruments
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so while the potential to earn is higher
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in such a case
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it might be due to an increase in the
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portfolio's credit and liquidity risk
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which is something all debt investors
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should be alert to
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and speaking about alertness if you
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haven't done this yet then do subscribe
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to the et money youtube channel
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to access more such videos and do tap on
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the notification bell
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so that you can receive alerts every
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time we upload a new video on the
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channel
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[Music]
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maturity is defined as the time period
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at the end of which the principal amount
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is returned to the bondholder
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now debt funds invest in many
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instruments each of which carry a
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different maturity
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this then requires the debt fund to
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calculate the portfolio's average
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maturity
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let's take a quick example here say a
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debt fund is invested in three bonds
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with a face value of 1000 rupees
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three thousand rupees and five thousand
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rupees each now these three bonds are
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maturing in three
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four and five years from now a quick
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weighted average would give us the
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average maturity of the debt fund which
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in this case comes to 4.4 years
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now the real question is what does
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average maturity tell us
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and how to use it when evaluating debt
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funds very simply the average maturity
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is a measure of the fund's sensitivity
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to interest rate changes
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and as a thumb rule higher the fund's
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average maturity higher is the interest
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rate sensitivity
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in fact here's a quick reckoner of the
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average maturities across
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different category benchmarks do notice
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that the liquid
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ultra short-term and low duration funds
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have a low average maturity and
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therefore are not much affected by
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interest rate changes
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however long duration and guild funds
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have a much higher average maturity
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and consequently have higher interest
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rate sensitivity
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now a common misapprehension here is
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that a higher interest rate sensitivity
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is not a good thing
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however if you recall from video one of
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the series you'll find that having a
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high interest rate sensitivity when the
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interest rates
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are on its way down can be a very
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profitable period for funds
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which carry long-term papers and play
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the duration strategy
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another related point here is that it is
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not uncommon to find different schemes
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within the same category
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having starkly different average
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maturities like in the case of dynamic
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bond funds where there
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are some schemes which have an average
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maturity of just three to four years
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while other schemes in the same category
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go as high as 10 years
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this variability in average maturity
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across schemes
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is mostly attributable to how fund
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managers view the direction
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and timing of interest rate changes so
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if the fund manager believes or
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for that matter if you believe that
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interest rates are going to fall
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then you would want to stack your
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portfolio with more long duration papers
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net net from an investor's perspective
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and understanding of average maturity is
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very important as it has a bearing
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on your investment horizon and the
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active management of your debt portfolio
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[Music]
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the macaulay duration is a measure of
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how long it will take for the price
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bond to be repaid from the internal cash
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flows of the bond
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let's start with a very crude example
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say you have invested in a thousand
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rupee bond which matures in 15 years and
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pays a coupon
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of 8 percent that's an interest of 80
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rupees every year which means you would
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have recovered your invested amount of
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1000 rupees
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in 12.5 years which is much before the
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15-year maturity of the bond
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now let's make this example more real so
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we have a thousand rupee bond at an
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eight percent annual coupon and a
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maturity of fifteen years
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further let's say the prevailing rbi
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interest rate is ten percent
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in this case here's how the macaulay
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duration is calculated
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first we map out the yearly cash flows
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which will be 80 rupees for each of the
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15 years
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and the 1000 rupee principle in the 15th
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year
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second we find the present value of each
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cash flow by discounting it by the 10
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interest rate third we apply the time
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weights
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to the present value such that the year
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1 cash flow of 72.7
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is multiplied by 1 then 66.1
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in year 2 is multiplied by 2 and so on
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and finally we total the time weighted
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cash flow
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present values and divided by the
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non-weighted present values to get the
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macaulay duration
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which in this case comes to 8.7 years
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now of course you don't have to
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calculate the macaulay duration yourself
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and the mutual fund fact sheet
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will give you that number what you
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really need to know is that a bond with
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a higher macaulay duration will be more
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sensitive
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to changes in interest rate and we'll
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understand a bit more of this when we
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study modified duration
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the modified duration measures the bonds
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price sensitivity relative to a change
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in its yield to maturity or the interest
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rates
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okay this might sound a little
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complicated but very simply if the
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modified duration of a bond is say
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five years and the interest rate goes
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down by one percent
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then the bonds price will increase by
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five percent
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notice that when the interest rate goes
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down the bond prices go
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up and that happens because of the
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inverse relationship
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between interest rates and bonds
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similarly if the interest rate had gone
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up by one percent
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then the price of the bond would have
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gone down by five percent now the reason
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why we covered the macaulay duration
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before the modified duration
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is because the formula for calculating
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the modified duration
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is derived from the macaulay duration
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itself in fact let's apply the formula
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on the previous example
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the macaulay duration in that case was
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8.7 years the ytm is 10
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and the frequency of receiving the
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coupon is one that is once per year
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which means the modified duration is
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eight point seven divided by one
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plus ten percent divided by one which
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comes to seven point nine years
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and how do we interpret the seven point
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nine since the modified duration
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illustrates the effect of a one percent
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change in interest rates on the price of
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the bond
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therefore if the interest rate increases
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by one percent
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the price of this bond will decrease by
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seven point nine percent
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and if the interest rate decreases by
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one percent then the price of the same
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bond will increase by 7.9 percent
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okay now that we have learned this let's
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see how we can put this data to use
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for one the modified duration analysis
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indicates the fund manager's view on the
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movement of interest rates
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so if a debt fund is having a lower
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modified duration
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then it's probable that the fund manager
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expects the interest rates to increase
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this will be a reason for him or her to
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opt for short duration papers
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to soften the impact of a price fall but
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if the fund manager expects a drop in
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interest rates then he or she is likely
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to keep the modified duration high
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another application of modified duration
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is your own selection of debt funds
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so say you want to minimize interest
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rate risks in that case it makes perfect
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sense to select funds with a low
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modified duration
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by low i mean 1 year maybe 1.5 years
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but definitely within 2 years in fact
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investors with a low risk appetite
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should stick with debt funds which have
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a low modified duration
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but if you have a moderate or a lot more
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risk appetite
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they can opt for a higher modified
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duration but remember
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one should never decide on the basis of
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an isolated variable
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you have to start evaluating on the
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basis of the ytm
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the rbi interest rate cycle the fund's
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credit risk performance expense ratio
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and a few more variables and then decide
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on which funds
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one should invest in actually let's look
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at a very interesting example on how you
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can project your next one year's return
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by using some of the variables we have
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discussed here let's say you select a
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fund with a modified duration of six
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years which has a y team of eight
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percent
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the expense ratio of this fund is one
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percent and there is an expectation that
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interest rates will go down
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by half a percent during the year in
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that case your expected returns would be
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the ytm plus the interest rate changes
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multiplied by the modified duration
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minus the expense ratio this comes to
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eight percent plus
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half a percent multiplied by six which
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comes to three percent
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so eight percent plus three percent
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that's eleven percent
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minus the one percent expense ratio
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which all totals up to ten percent
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so the expected returns for the year
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from this fund is ten percent
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assuming your expectation of a 0.5
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drop in interest rate fructifies now
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instead of the rbi reducing the interest
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rates by 0.5 percent
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say it increases the interest rate by
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0.5 percent
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in this case the expected returns would
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be eight percent minus three percent
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minus one percent
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expense ratio which comes to four
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percent of course this
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interest rate ulta pulta may happen or
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may not happen but the idea here was to
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explain
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how you can practically use what we have
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learned in this video so far
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for more insights on these quantitative
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factors you can access
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a number of other sources for one
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crystal publishes data related to its
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debt-based indices
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every month in fact here's a screenshot
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from the first march
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2021 fact sheet which shows the average
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ytm
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average maturity average macaulay
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duration and the average modified
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duration for the most
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important debt-based indices another
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source to know about these indicators
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are the monthly fact sheets that are
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published by the mutual fund companies
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and are available on their website
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and of course you can access these and
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even more information
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on the et money app and website which
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features thousands of different schemes
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in a simple and comparison friendly
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format
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the portfolio of a debt mutual fund is
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available in the fact sheet and offers
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six different types of information
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these include the types of instruments
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in which the scheme has invested
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the bond issuers the coupons offered the
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maturities of the paper
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the risk profile depending on the credit
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rating of the issuers
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and finally the weightage of each
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instrument in the portfolio
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the type of bond issuer and the credit
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rating is an important determinant in
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fund selection and something the
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investors should look out for
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to put it simply schemes which invest in
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government securities or papers with
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high credit rating or both
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come with a low issuer default risk
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which is more suitable for risk averse
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investors
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another area to look out for is the
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concentration risk in debt mutual funds
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a concentration risk arises when a
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scheme holds a disproportionately high
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part of the aem with a single issuer
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this
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in turn exposes the portfolio to a
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higher amount of risk if this
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issuer might default or if that bond
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prices might drop for whatever reasons
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having said this a good practice that a
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debt fund investor can employ
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is to avoid having too many debt funds
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from the same mutual fund company
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the reason for suggesting this is based
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on the observation that different
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debt schemes of the same amc tend to
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invest in similar papers
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which can create unnecessary
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concentration risk in your portfolio
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by spreading across different amc's you
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have a better chance of lowering the
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concentration risk
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[Music]
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risk or meters have been featured in
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fact sheets since 2015 but it's only
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starting january of this year
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that risk or meters really started
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becoming a useful tool
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in investing decisions because starting
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this year the sebi
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directed all mutual fund companies to
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move to a new
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six level risk ometer which aims to make
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risk scoring a more scientific pursuit
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specific to debt funds a scheme's risk
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is now calculated as an average of three
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risk categories
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the credit risk the interest rate risk
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and the liquidity risk
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and from the looks of it the new risk
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ometer can actually act as the first
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alert signal to all debt fund investors
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and here are the reasons why firstly the
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new risk ometer is a standardized tool
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and is an easy to understand way of
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assessing risk levels for the everyday
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investor
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two the schemes within the same category
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can have
[968]
different risks so depending on their
[970]
credit interest rate and liquidity risk
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this allows for meaningful comparisons
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between schemes within the same category
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and finally all fund houses need to
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update their scheme risk score every
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month
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and communicate any change of risk to
[985]
the unit holders in a templatized format
[987]
this regular monitoring will allow
[989]
investors to be alert to rising risk
[991]
levels
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we can definitely assist in better
[993]
decision making
[998]
for too long most investors including me
[1000]
have been taking their debt fund
[1001]
decisions
[1002]
on recognizable factors such as the one
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year performance the three acr
[1007]
exit load expense ratio am size and to
[1009]
some extent the portfolio mix of the
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scheme
[1012]
we certainly hope this video has been an
[1014]
eye opener for you and you would
[1015]
want to use this opportunity to relook
[1017]
at your debt portfolio
[1019]
with more emphasis on the yield to
[1021]
maturity average duration modified
[1023]
duration
[1024]
concentration risk and the changes in
[1025]
the risk of meter
[1027]
do let us know which part of the video
[1029]
you particularly liked and would want to
[1031]
implement pronto in the comments box
[1032]
below
[1033]
i hope you liked our content and will
[1035]
draw many learnings from the information
[1037]
and
[1037]
insights presented don't forget to
[1039]
subscribe like comment and share this
[1041]
video with your friends and colleagues
[1043]
thank you for watching and i look
[1044]
forward to catching up with you next
[1046]
week with another insightful video
[1048]
until then mutual fund investments are
[1050]
subject to market risks
[1052]
read all scheme related documents
[1054]
carefully
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