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Understanding Macaulay Duration In Bond Trade

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Understanding Macaulay Duration In Bond Trade
Deepika Asthana - 01 May 2020

When it comes to investing in debt mutual funds, the Securities Exchange Board of India (SEBI) has categorised these funds as per their Macaulay Duration. It is time to understand what this term means and how it can impact our decision to invest in a particular debt mutual fund.

What is it Macaulay duration?

Macaulay duration basically measures how long it takes for the price of a bond to be repaid by the cash flows from it. When you invest in a bond, you pay a certain price for it. Macaulay duration tells us how much time it would take for the investor to recoup the price paid for. This repayment is made by way of periodic interest as well as principal repayments. The Macaulay duration is measured in years and is calculated as the weighted average time period over which the cash flows on its bond holdings are received

Why is it important?

It is well known that bond prices have an inverse relationship with interest rates ie., when interest rates fall bond prices rise and vice versa. On the other hand, bonds that have a longer maturity period are more sensitive to changes in interest rates than bonds that have shorter maturity periods. Which means that when you invest in bonds that have a longer maturity, you are facing higher duration risk. This is why it is important to know the Macaulay duration of the mutual fund bond portfolio that you are investing in.

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. Just like the risk of equity investments can be measured by calculating standard deviation or beta, the risk of bonds investment can be measured by Macaulay or Modified duration and the credit rating of the bond.

Investing can be challenging even in the best of times. Thus, it is important to understand the very basics of measuring investment risks and then making an informed investment decision.

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