What is Macaulay duration concept and how it helps you to choose right debt mutual fund?
As per SEBI recategorization of mutual funds, all debt funds need to be classified into buckets based on Macaulay duration. Macaulay duration is indicated in the scheme information document (SID) of the mutual fund scheme. Often, many mutual fund investors keep getting this doubt what is this Macaulay duration and should we really worry about it. Understanding this concept would help to invest in right debt mutual fund scheme. What is Macaulay duration concept in debt funds all about? How investors needs to pick right debt funds to get higher returns?
Also Read: Best Debt Mutual Funds to invest in 2020
What are debt funds and how Macaulay duration relates to it?
Debt mutual funds in simple terms would invest in debt related instruments based on the investment objective. However, each and every debt mutual fund would invest either for 3 months or 6 months or 1 year based on the investment objective as well as Macaulay duration concept. Hence, understanding Macaulay duration concept would help mutual fund investors to pickup a right mutual fund scheme.
What is Macaulay duration concept?
Let me explain this concept with few pointers.
1) The Macaulay duration measures the weighted average term to maturity of the bond’s cash flow. The weights in this weighted average are the present value of each cash flow as a percent of the present value of all the bond’s cash flows.
2) Macaulay’s Duration is linked to the price volatility of a bond.
3) This duration is the fund manager’s tool for structuring a portfolio of bonds to have the desired sensitivity.
How Macaulay duration of the portfolio is computed?
Here is how this duration is computed.
t = respective time period of the bond or debt instrument
C = periodic coupon payment made by the bond or debt instrument
y = periodic yield of the bond or debt instrument
n = total number of periods of the bond or debt instrument
M = maturity value of the bond or debt instrument
P = market price of bond of the bond or debt instrument
How to interpret Macaulay Duration?
This metric is named after its creator, Frederick Macaulay.
1) The Macaulay duration can be viewed as the economic balance point of a group of cash flows of the debt fund.
2) Another way to interpret the statistic is that it is the weighted average number of years an investor must maintain a position in the bond until the present value of the bond’s cash flows equals the amount paid for the bond.
What factors that would affect Macaulay Duration?
A bond’s price, maturity period, coupon rate and yield to maturity (YTM) all factors into the calculation of duration.
Keeping remain things constant, maturity increases, duration increases.
As a bond’s coupon increases, its duration decreases.
As interest rates increase, duration decreases and the bond’s sensitivity to further interest rate increases go down.
Also, a sinking fund in place, a scheduled prepayment before maturity and call provisions lower a bond’s duration.
Computation of Macaulay duration of the portfolio – With an example
Here is how the Macaulay duration of the portfolio is computed for the ultra short term duration (a fund that invests in instruments that matures between 3 months to 6 months). This sample portfolio is computed as on 31 May, 2020.
If you observe the Macaulay duration is 0.48 years, i.e. nearly 6 months, but little lesser. Means any investor who want to invest in these funds can get higher returns if they are willing to invest for at least 6 months. If your investment horizon is say 2 months or 3 months, you may get lower returns. Ultra Short Term Funds, Short duration Funds, Medium duration funds and long duration funds would consider this Macaulay duration and invest based on the concept.
Example of wrong ways of investing: Investing in Ultra Short Duration Fund for 1 month or 2 months, whereas the ideal period should be from 3 to 6 months (based on Macaulay concept).
Hence, if you are investing in those debt funds, check the Macaulay concept and invest in appropriate debt fund to get higher returns.
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