If you are looking to invest for a short term goal which is less than 5 years away, what kind of debt fund would you choose?
Simple answer to the above question is 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 parameters are when it comes to selecting debt schemes.
Two important parameters for choosing the right category of debt mutual 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 have its own maturity date.
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 teh lower average maturity.
2) MODIFIED DURATION
The modified duration (not to be confused with maturity) is the measure of price sensitivity of the fund to change in interest rates. Funds with a longer modified duration would be more sensitive to a given change in interest rates. For example, a bond / fund with a modified 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 modified duration!
Higher the modified duration higher would be the interest rate risk!
Funds with the higher duration tends to give the higher return in falling interest rate scenario, but in case of rising interest rate scenario it can generate the negative return.
So it is always better to create your portfolio with the schemes that suits the interest rate cycle keeping in mind the modified duration of the fund.
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