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5 Basic Terms To Know About Debt Funds

Tags: Mutual Funds Basics

Investing in a debt fund is quite different from buying a bond.

With the evolving financial markets, debt funds are seen as an alternative to traditional investment products. Such funds invest in debt securities and money market securities to generate returns for the investors. Such funds mainly invest in Govt. Securities (G-Secs), Corporate Bonds, money market instruments, etc. Here are five basic terms to know about debt funds:

1	Yield	It refers to the effective returns that debt security will generate for the investors. At the time of the primary issue of debt security at face value, the yield will be equal to the coupon rate—however, the valuation of debt security changes with changes in interest rates. The yield of such security is inversely proportional to the price. When the price of the security increases, the yield of such security decreases, as the investors will get the same coupon and redemption value with higher investment.
2	Yield to Maturity	Yield to Maturity refers to the yield generated by the different securities within the debt portfolio if such portfolio is left untouched till maturity. The ratio is primarily used to denote the current return potential of the debt fund and is also disclosed by the mutual funds in the monthly fund fact sheets.
3	Credit Ratings	Credit ratings tend to gauge the credit risk profile of the issuer entity and the debt security. While it may not be feasible for the investor to check the financial health of each issuer entity, credit ratings make the task easier with standardized credit rating grades. Such grades may range from AAA reflecting the highest level of safety to D, reflecting that the entity has defaulted on its debt servicing. One can check the portfolio health by reviewing the portfolio composition into different credit ratings. Further, the return expectations may be moderated by the investors after reviewing the credit profile. This is because credit risk and returns are inversely proportional, meaning that the safer investment products with AAA credit ratings will carry lower returns for the investors than those issued by a BBB-rated entity.
4	Modified Duration	It reflects the sensitivity of the debt portfolio to the interest rate movements. While the portfolio valuation is inversely proportional to the changes in the interest rates, the impact of such interest rate changes is directly proportional to the modified duration of the investment portfolio. Higher the modified duration, the higher the changes in the portfolio valuation due to changes in interest rates. For example, if the debt portfolio has a modified duration of 4.0, every one percent change in the interest rates will lower the portfolio valuation by four percent. It is always advisable to invest in funds with lower modified duration when the interest rate outlook shows an increasing trend. Similarly, when the interest rates are expected to trend downwards, it is advisable to invest in funds with a longer duration.
5	Weighted Average Maturity	This refers to the average maturity of the debt securities in the investment portfolio of the debt fund. It is the average time taken by the securities to mature, with weights as that of the outstanding amount. While the maturity of the portfolio investments in close-ended funds remains the same, the figure for open-ended funds remains dynamic due to the movement of the securities within the investment portfolio. Further, the average maturity and the modified duration don’t measure similar data since the average maturity measures the period over which the principal amount can be expected to be received. In contrast, modified duration measures the period for which the interest rate continues to be the same.