What is Modified Duration?
Duration – Measure to know what changing interest rates could do to your fixed income portfolio….
Modified Duration expresses the sensitivity of the price of a bond to a change in interest rate.
The price of a bond and interest rates have an inverse relationship, i.e. if the interest rates rise, the price of the bond would fall and vice versa.
The modified duration explains the extent of rise or fall in bond price, given a change in interest rate.
Bond Duration and Mutual Funds
Investors can choose to invest in the fund as per their risk appetite and view on the interest rates. The average duration of the bonds in the portfolio can be found in the fund factsheets. The duration of a portfolio equals the weighted average duration of all bonds in the portfolio. The portfolio duration can be used to infer how the value of the portfolio would change in response to changes in interest rates.
So if we arrange the fixed income funds of mutual funds in order of their duration (interest rate sensitivity). The liquid funds/ cash management funds will have near zero duration rate risk, so this kind of funds suitable to the investors who want stable returns with daily liquidity option. Ultra-short term debt funds will have higher interest rate sensitivity than liquid funds, but lower than other debt funds.
The short term debt funds will be prone to moderate interest rate risk. The funds like long term gilt funds/ long term income funds will have highest interest rate sensitivity.
Dynamic Bond Funds have the flexibility to modify the duration based on views on the interest rate cycle. These funds can invest in short duration instruments like CD/CPs, if they feel interest rate rises and they can invest in long duration government securities and corporate bonds, if they feel interest rates will fall. Hence these funds have moderate interest rate sensitivity.
If a Fund Manager feels that the interest rates are going to rise, he would reduce the modified duration of the portfolio. Alternatively, if he feels that the interest rates are to fall, he will maintain a higher duration and benefit from the fall in interest rates.
So if an investor expects interest rates to fall during the course of the time of the investment, a long duration fund would be appealing because the funds would offer better return than funds with shorter durations.
How does Duration impact fund returns
For most investors, the primary importance of bond duration is that it predicts how sharply the market price of a bond will change as a result of changes in interest rates.
For example: If a 10-year Government security has duration of 6 years, and interest rates for 10-year Government security increase by 1%, the bond’s price will fall by ~6% and if 10-year Government bond interest rates fell by 1%, the bond’s price would increase by ~6%.
Few key points about duration:
- A “Bond” with a lower “modified duration” implies that the “returns” are more from accrual income than from capital gains.
- “Bond” with a higher “modified duration” implies that the “returns” are more from capital gains than from accrual income.
- Lower a bond’s coupon, the longer its duration. Higher a bond’s coupon, the shorter its duration.