Here, we will discuss Debt Schemes, and it’s classifications.
What is Debt Fund?
A debt mutual fund invests primarily in debt instruments or fixed income securities such as Treasury Bills, Corporate Bonds, Money Market Instruments, and other debt securities with different time horizons.
Debt fund securities have a predetermined maturity date and a predetermined interest rate. As a result, debt funds can be counted on to provide a low rate of interest over time. They also have a very low-risk rating. Debt funds are an interesting part of a wise investor’s portfolio because of their safety.
What do the terms Maturity and Duration imply?
When we talk about debt funds, we frequently hear the phrase above. In fact, rookie investors use them interchangeably. Both words may appear to be the same, yet they have different meanings in the financial world. In English, duration refers to the amount of time, while maturity refers to the degree to which something has matured.
The term “maturity” refers to how long it will take for a debt instrument’s principle to be repaid. A five-year bond or debt instrument, for example, pays interest for five years from the date of purchase. The maturation period is 5 years in this case. The bond principal is paid back to the owner at the end of the five years, and interest payments are no longer made.
The time between now and when the bond matures is typically referred to as maturity by the investor. A debt instrument’s maturity date is normally fixed at the time of issue and does not alter. The maturity of a debt instrument, on the other hand, shortens as the instrument’s life approaches its maturity date.
Duration is a more abstract and perplexing concept that is used to determine the interest rate’s sensitivity. It means it assesses how sensitive a fixed-income investment’s principal is to interest rate changes.
Bond market investors pay close attention to interest rate swings because they have the opposite effect on bond prices. The value of a debt instrument decreases as interest rates rise, and vice versa. The term “duration” is commonly used to refer to the number of years.
Understanding Duration in further depth:
When employed as an indication, duration is influenced by various factors such as present value, yield, coupon, eventual maturity, and call features. Simply said, the longer the term, the more interest rate risk or reward there is for bond prices.
The notion of duration allows investors to compare bonds and debt funds with a variety of coupon rates and maturity dates. Because the duration is defined in years, a longer duration for a debt-oriented investment means that investors will have to wait longer to get coupon payments and the capital invested. The higher the duration value, the more likely the price of the investment will fall if the interest rate rises. It’s also true in the other direction.
A Case Study:
For example, Rishav is currently deciding on debt funds for his portfolio. His preliminary research indicates that interest rates will rise in the next three years, and he may decide to sell the bond funds before the maturity date. As a result, when investing, he will need to consider the duration, and he may wish to invest for a shorter period of time.
Suppose Shreya 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, she 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, Shreya would receive Rs. 30 per year and would receive the Rs. 1,000 principals invested.
Therefore, Shreya 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.
Read Next: “Portfolio Management.”
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