Average Maturity, Macaulay Duration, and Modified Duration of Debt Funds

Debt funds are a popular investment option among investors looking for lower volatility and steady income. The tax benefits enjoyed by debt funds add to their attraction.

However, there are a few terms that you must know in order to get a better understanding of how debt funds work.

How do Debt Instruments Work?

Debt funds are a type of mutual fund that invests in various fixed-income securities like bonds, government securities, and money-market instruments. These funds earn a fixed income in the form of interest and have a predetermined maturity date.

Unlike instruments like a fixed deposit, where the investor is virtually assured of the exact return he will get (except in cases of default), debt instruments are prone to certain fluctuations as the price it gets bought and sold can vary from day to day.

Let’s understand with an example-

Imagine a borrower raises Rs 1 lakh by selling a one-year bond. The bond is made up of 1,000 units of par value Rs 100 each, and the coupon rate promised on the bond is 12% paid out semi-annually.

If the investor were to buy this bond and hold it to maturity, he would get a Rs 6,000 coupon payment twice—once each at the end of Month 6 and Month 12, along with the principal amount of Rs 1 lakh at maturity (end of Month 12). Much like an FD, there is no other risk involved except the default risk.

However, if the investor wishes to sell the bond in the market at Month 5, he may not get the price of the bond unit at Rs 105, even though the bond has accrued 5% interest so far.

This is because the bond is subject to several risks, which will get priced in by prospective buyers.

The most important is interest rate risk (similar debt instruments are now yielding higher interest rates). As you may tell, if general interest rates in the market rise, the prices of existing bonds will likely fall. Hence, it is said that bond prices and interest rates are inversely correlated.

Other risks include liquidity risk (lack of a buyer) and credit risk (the financial situation of the issuer of the bond may have changed). 

Understandably, all of the above risks will tend to be higher if the bond has more time left for maturity, as there is more time for each of the risks to materialise.

There are a few metrics that help you interpret maturity and the connection with bond prices, such as average maturity, Macaulay duration, and modified duration. Here’s an explainer.

What does Average Maturity mean?

Understanding the average maturity of a debt fund can help investors plan and make sound decisions during various interest rate cycles.

A debt fund consists of several bonds or debt instruments with varying maturity periods. The average maturity in mutual funds helps an investor know the average time in which all the debt securities in a fund will mature.

The average maturity takes into consideration the maturity periods of the individual debt instruments within a fund. The weighted total of all instruments is divided by the face value of all the instruments in a fund to calculate the average maturity. 

Let’s understand it better with the help of an example-

Average Maturity = (4,000 + 16,000 + 30,000)/(2,000 + 4,000 + 6,000)

Average Maturity = 4.16 years.

The average maturity is a valuable metric for navigating different interest rate environments. Funds with a longer average maturity may see price declines and increased risks when interest rates rise. Meanwhile, funds with a shorter average maturity are relatively less volatile in the case of rising interest rates.

What is Macaulay Duration in Mutual Funds?

The Macaulay duration is another significant metric that helps an investor analyse the price sensitivity of debt securities in relation to the interest rate. Macaulay duration signifies the weighted average duration of a debt security to repay the principal amount, including coupon payment.

The Macaulay duration is directly correlated to the maturity date. Securities with a longer maturity will have a longer Macaulay duration.

Further, the Macaulay duration in mutual funds is also a great metric to study a fund’s sensitivity to interest rates. Funds with a longer Macaulay duration are more sensitive to interest rates and are subject to heightened price volatility.

A rise in interest rates results in a decline in the value of future cash flows, which negatively impacts debt securities with a long duration. On the contrary, longer-duration securities see an increase in price with a decline in interest rates.

The Macaulay duration in mutual funds is calculated using the following formula:

What is Modified Duration?

Modified duration in mutual funds is a key metric to gauge the magnitude of sensitivity of a debt security to changes in interest rate. The modified duration signifies the percentage change in the price of a security for a 1% change in interest rates.

For Example, 

If a debt security has a modified duration of 5 years, then a 1% rise in interest rates will result in a 5% fall in the price of the security. Conversely, a 1% fall in interest rates will result in a 5% hike in the debt security’s price.

The modified duration is similar to the Macaulay duration but is differentiated as it takes the present value of a bond’s cash flows and adjusts it to the interest rate or yield to maturity (YTM). Like the Macaulay duration, the longer the modified duration, the more susceptible a fund is to price volatility.

The YTM is a representation of the quality of securities in a debt fund and the prospective returns of the scheme. A higher YTM signifies that the fund’s portfolio consists of bonds of inferior quality that have the potential to deliver high returns but also carry higher risks.

The modified duration in mutual funds is calculated as:

The modified duration is a key metric as it can help fund and portfolio managers manage their portfolios’ exposure to interest rates. Modified duration can help in mitigating interest rate risks and aid in decision-making in various interest rate scenarios.

Difference between Average Duration, Macaulay Duration, and Modified Duration