For an investor in a debt mutual fund, it is important to know initially the duration and how it will be managed. Any interest rate changes tend to influence the price of a bond.
The interest rate sensitivity of a debt mutual fund and its impact on a particular scheme’s net asset value (NAV) is highlighted by modified duration (MD). Modified duration in debt mutual funds measures the change in the value of a fixed-income security from a single percentage change in interest rates or yield to maturity (YTM), which is the potential returns of a debt bond. A higher YTM is equal to a higher return. The underlying portfolio could be of lower quality indicating a higher risk.
Modified duration highlights a security’s sensitivity to interest rates. It showcases how much the change in the interest rate will change the value of the debt mutual fund. Modified duration is based on the concept that bond prices and interest rates move inversely. Simply put, it highlights the effect of a 1% change in the interest rate on the price of the debt mutual fund. For instance, if the modified duration is five years, a 1% dip in the interest rate will lead to a 5% rise in the price of the bond and vice-versa.
In short, debt mutual funds with a longer modified duration will witness a greater movement in NAV depending on the movement of interest rates as compared to debt funds with shorter MD. As per an investor’s appetite for risk, one can choose a debt mutual fund with lower or higher interest rate sensitivity.
Rajiv is an independent editorial consultant for the last decade. Prior to this, he worked as a full-time journalist associated with various prominent print media houses. In his spare time, he loves to paint on canvas.