Debt fund securities have a fixed maturity date and pay a fixed rate of interest. So, debt funds can be relied upon to give a minimum rate of interest over a time period. Also, they rank very low on the riskometer. This secure nature of debt funds makes them an interesting component of a smart investor’s portfolio.
We often hear the above two terms when we are talking about debt funds. In fact, they are used interchangeably by novice investors. Both words may seem alike but have varied meanings in a financial context. In English, duration stands for the length of time, and maturity means the extent to which something is fully grown.
Maturity of a debt instrument is the length of time until the principal is supposed to be paid back. So, a 5-year bond or debt instrument earns interest for five years from the date it is purchased. Here, the maturity is 5 years. At the end of 5 years, the bond principal is repaid back to the owner and the interest payments cease.
According to the investor, maturity is commonly referred as the time between now and when the bond matures.The maturity date for a debt instrument is usually set at issue and doesn’t change. However, the maturity of a debt instrument gets shorter as the instrument’s life as one moves closer to that maturity date.
Duration is relatively a more abstract and confusing concept employed to ascertain the sensitivity of the interest rate. This implies it measures the value of the principal, for a fixed income investment to a change in interest rates.
Investors in the bond market often pay attention to fluctuations in interest rates since these movements have opposite effects on bond prices. An increase in interest rates lowers the value of a debt instrument and vice-versa. Duration is expressed usually in terms of the number of years.
Duration, when used as an indicator, depends upon other metrics including present value, yield, coupon, final maturity and call features. Speaking simply, the bigger the duration, the greater the interest-rate risk or reward for bond prices.
For investors, the concept of duration enables them to compare bonds and debt oriented funds with a number of coupon rates and maturity dates. Since duration is measured in years, if a debt oriented security instrument has a higher duration, it means that investors would need to wait a longer period to receive the coupon payments and principal invested. The higher is the value of duration, the more is the likelihood that the security’s price would fall if the interest rate rises. The reverse is also true.
For example, Ron is in the process of selecting debt funds for his portfolio. His initial research makes him believe that interest rates will rise over the next three years and may consider selling the bond funds prior to the maturity date. So he will need to consider the duration at the time of investing and he might wish to invest for a shorter duration.
Suppose Ron wishes to purchase a 15-year bond that yields 6% for Rs. 1,000 or a 10-year bond that yields 3% for Rs. 1,000. If the 15-year security is held to maturity, Ron would receive Rs. 60 each year and would receive the Rs. 1,000 principal after 15 years. Conversely, if the 10-year bond is held until maturity, Ron would receive Rs. 30 per year and would receive the Rs. 1,000 principal invested.
Therefore, Ron would want to consider 10-year bond because the bond would only lose 7%, or (-10% + 3%), if interest rates rise by 1%. However, the 15-year bond would lose 9%, or (-15% + 6%), if rates rose by 1%. However, if interest rates get reduced by 1%, the 15-year security would rise more than the 10-year bond.
To know more about debt funds see also – Debt Funds: Types, Benefits and More