Understanding the Key Parameters of Fixed Income Funds | LTMF
This article will help you understand the key parameters of fixed income funds & why changes in interest rates affect the prices of bonds or fixed income securities.
In fixed income / bond funds, the two most important sources / drivers of return are:
Interest accrual which is the periodic interest or coupon earned from the underlying fixed income securities and capital appreciation / depreciation on account of changes in the price of the underlying security in the portfolio (bond prices are inversely related to interest rates or yields).
Average maturity and modified duration of a bond fund’s portfolio could help in assessing what kind of capital appreciation / depreciation could take place in the NAV in case the interest rates move upward or downward with a given magnitude.
But before we try and understand these measures, let’s first understand why changes in interest rates affect the prices of bonds or fixed income securities.
Consider the following example:
Let’s say you have invested in a bond which gives you 10% interest / coupon payment every year for next five years. So if you invest Rs. 1,00,000 today, you will receive Rs. 10,000 at the end of every year for the next 5 years, and repayment of the principal amount of Rs. 1,00,000 at the end of 5 years.
Now let’s assume that exactly one year later, the issuer pays 8% interest on newly issued bonds of 4 year maturity (assuming all other parameters and conditions to be unchanged). This new bond is similar to the one you own in a way, because at that point of time the residual or remaining maturity of your bond will also be 4 years. However, the interest that you are going to earn on your security will be 10% and not 8%, as you had bought that security in the previous year when interest rate offered was 10%.
Now assume that you want to sell or transfer your security exactly after one year (once you receive the first interest payment of Rs. 10,000); would you sell the security at the purchase price of for Rs. 1,00,000 or would you ask for a higher or lower price?
You will obviously want to sell it at a higher price because the security that you are holding will continue to give you 10% whereas a similar security issued newly by the same issuer will earn 8% - so you can charge higher for the security that you own.
Let’s take another example now. Assume you had bought another fixed income security one year back with initial maturity of 10 years (after 1 year residual its remaining maturity will be 9 years) at 10% interest rate per annum. Now, assume that the same issuer is giving 8% interest on a 9 year security. In this case again, you will be able to sell the security that you own at a premium.
Moreover, the premium that you charge for this security can be higher than the one charged for the earlier security which has residual maturity of 4 years, because the security with residual maturity of 9 years will continue to pay 10% interest for next 9 years whereas the other security will pay 10% interest for only 4 years.
In other words, when interest rates fall, price of securities with higher maturity will appreciate more than the price of securities with lower maturity. On the other hand, if the interest rate paid on bonds by the same issuer increase to 11% after 1 year, the price of the bond that you hold would be below Rs. 100,000 because it would become less attractive due to lower coupon interest. And the depreciation in price of security with residual maturity of 9 years would be higher than the security with residual maturity of 4 years.
Simply put, given all other parameters being equal, the securities with higher residual maturity are likely to be more sensitive and volatile to changes in interest rates.
Although in real life, coupon rate, coupon payment frequency, residual maturity etc. may vary across different securities and hence refined measure such as modified duration is used to measure interest rate risk. While maturity may give some information about the interest rate risk, modified duration provides a better idea including the potential impact on price of the bond for a given change in interest rate.
Modified duration is typically driven by three factors:
Residual maturity: Higher the residual maturity, higher the modified duration
Coupon rate: Higher the coupon rate, lower is the modified duration
Yield-to-Maturity: Higher the YTM, lower is the modified duration (YTM is the prevailing yield of the bond, based on its market price, coupon rate and time remaining to maturity)
Some of the key points to remember
Since there are three main variables which drive modified duration of a bond, it is not appropriate to assume that a bond with higher residual maturity will always have higher modified duration. It is advisable to use modified duration instead of residual maturity to understand interest rate risk of a bond better.
Thus, modified duration not only helps calculate the impact of interest rate change on NAV of the fund but also in comparing bond funds to understand their relative interest rate risk / sensitivity to interest rate changes. However apart from modified duration, there are other parameters such as credit quality, credit ratings, liquidity, etc which can also drive the bond prices. And hence, modified duration has to be looked at in conjunction with other such variables.
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