If you’re a regular investor in mutual funds, you may now need to understand a new term to navigate the maze of debt mutual funds. SEBI’s new norms on categorisation of mutual funds require fund houses to classify their debt schemes into clearly defined buckets based on their Macaulay Duration.

What is it?

Macaulay duration, named after Frederick Macaulay who developed the concept, is a measure of how long it takes for the price of a bond to be repaid by the cash flows from it. In layman terms, it is the time an investor would take to get back all his invested money in the bond by way of periodic interest as well as principal repayments. The Macaulay duration for a portfolio is calculated as the weighted average time period over which the cash flows on its bond holdings are received. It is measured in years. The Macaulay Duration of a debt fund is nothing but the weighted average Macaulay Duration of the debt securities in the portfolio.

Why is it important?

You may know that bond prices are inversely related to interest rates. When rates rise, bond prices fall and vice versa. A bond with a longer maturity period is more sensitive to changes in interest rates than a bond with a short duration. Thus, investors must stay with funds or bonds with longer maturity when interest rates are expected to go down and move to bonds or funds with short maturity when interest rates are either likely to stay stable or go up. This makes it important for an investor to know the Macaulay Duration of a fund before buying it.

However, investors may find the Modified Duration an even better measure of a fund’s sensitivity to interest rates. As the name suggests, this is a modified version of the Macaulay model that accounts for changing interest rates. Modified duration is calculated simply dividing the Macaulay Duration by the portfolio yield. It measures the change in the value of a fixed income security that will result from a one per cent change in the interest rate.

While Macaulay Duration is the parameter used by debt fund managers to construct portfolios that are well suited to prevailing current market conditions, modified duration is the preferable criterion for an investor to use while choosing his fund. Investors can also consider ‘average maturity’, a tool that measures the weighted average maturity of the all bonds constituting a portfolio.

Why should I care?

Portfolio duration plays a key role in helping debt fund investors measure the risk of the fund they are buying into. Just like the risk in equities is measured through standard deviation or beta, the risk in bonds is measured through credit profile and Macaulay or Modified duration.

Understanding the Macaulay Duration can help you choose the right debt funds to suit your investing horizon. Post SEBI rationalisation, of the 16 categories of debt funds, there are eight categories based on the Macaulay Duration – Ultra short duration, Low duration, Short duration, Medium duration, Medium to long duration, Long duration, Dynamic bond, Gilt fund with 10-year constant duration. The new norms aim to bring uniformity to debt schemes and ensure that comparisons between schemes in the same bucket are an apples-to-apples comparison.

The bottomline

Look into duration before you leap into debt fund investing.

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