In the real world, the average age of a group of people is an important indicator. Be it the average age of the population, an MBA class, a sports team, or even members of Parliament. For debt funds too, a similar concept called average maturity is used. The maturity of an instrument—say, an insurance policy or a bond—is nothing but the time when it matures. It is the length of time till the principal is returned to the security-holder or bond-holder. For example, the RBI Relief Bond has a maturity period of five years, after which the principal is returned to the investor.
More specifically, average maturity applies to debt mutual funds. These funds usually invest in a number of bonds and gilts, with each instrument having a different maturity. And since maturity of a security doesn't give you a clear picture about the fund's maturity profile, funds usually disclose weighted average maturity. For example, if a fund owns three bonds of 2-year (Rs 30,000), 3-year (Rs 10,000) and 5-year (Rs 20,000) maturities, its weighted average maturity would be 3.17 years.
However, average maturity does not indicate the life of a fund. An open-end fund never matures. Illustratively, if you invest in a bond fund having an average maturity of six years, you don't have to hold the fund for six years, you can sell it the next day. Basically, what it means is that the maturity of a fund's bond holding is six years.
You may ask what is the big deal about average maturity? More explicitly, average maturity tells you how sensitive a bond fund is to change in interest rates. When interest rates move down, bond prices move up, thus boosting debt funds' return and vice versa when rates move up. However, a change in interest rates will impact different maturities differently. The price of long-term debt securities generally fluctuates more than that of short-term securities when the interest rate changes. Consequently, mutual funds with several long-maturity papers in its portfolio are more sensitive to NAV fluctuations.
For example, among all debt medium-term funds, PNB Debt Fund has the highest average maturity (8.6 years as on February 28, 2003). As a result, this fund's standard deviation—a measure of a fund's volatility—is also on the higher side in the category. UTI Bond, on the other hand, has an average maturity of just 4.78 years. Therefore, this fund is among the least volatile funds in the category.
Average maturity of a fund portfolio undergoes a change with the passage of time or when the portfolio is churned. As a debt security approaches its maturity date, the length of time to maturity becomes shorter. Thus, even if a fund buys and holds a debt portfolio, the average maturity of a fund keeps on decreasing till the security held reac-hes its maturity date. Also, if a fund sells one security and buys a fresh one, it is obvious that its average maturity will change too since each security has its own maturity period. As gilt funds usually have a relatively higher average maturity, they are the most volatile among all debt funds. Cash funds (debt ultra short-term funds), on the other hand, usually have the shortest average maturity and are the least volatile. But since higher risk also means higher returns, gilt funds are capable of delivering higher returns than cash funds. Thus, aggressive investors, who can stomach volatility, will find gilt funds palatable. Cash funds are suited to those who put stability ahead of returns. In a nutshell, what all this tells you is that the longer the average maturity, the higher the risk associated with a bond fund and, consequently, higher the volatility.