Low Duration Mutual Funds – Definition & Benefits Return & Risk
The Securities and Exchange Board of India (SEBI) has divided debt mutual fund schemes into 16 categories based on investment strategy and tenure.
A low-duration mutual fund is one such category. As the name suggests, the duration of the fund portfolio is low, ranging between 6 to 12 months. It holds assets with longer maturity and lower credit quality than overnight or liquid funds.
In this article, we will try to decode low-duration mutual funds, understanding how they function, their risks and returns, and more. So, let’s dive right in!
What are Low Duration Mutual Funds?
Low-duration mutual funds are types of debt mutual funds that invest in debt and money market instruments, with a Macaulay duration between six to 12 months.
Macaulay duration is the total weighted average investment term to the maturity of the cashflows from a debt instrument (typically a bond).
Low-duration mutual funds are suitable for investors with a lower-risk profile and an investment horizon of around one year.
They provide a higher maturity than the average liquid or overnight funds. However, the returns are lower than long, medium, and short-duration mutual funds. Typically, such funds offer returns ranging from 6.5% to 8.5%.
How do Low Duration Funds Operate?
To understand low-duration mutual funds, we must understand the meaning of duration in the context of mutual funds.
What is Duration?
Here, duration measures the period for which the fund’s value remains sensitive to market fluctuations. In other words, it measures how much the fund’s valuation moves up or down with changes in the underlying market interest rates.
Hence, this duration is also called the interest rate risk. The higher the fund’s duration, the greater its interest rate risk and the more volatile its value.
When a fund increases holding in long-term bonds, its duration also increases. Since the term of low-duration mutual funds is between 6 to 12 months, they are likely to invest in short-term securities.
What are the Investment Avenues for Low Duration Mutual Funds?
Low-duration mutual funds can typically invest in a wide range of debt assets, including:
- Securitized debt.
- Corporate bonds.
- Money market instruments.
- Government bonds.
- Hybrid instruments, such as permitted derivatives or REITs, etc.
How Do Low Duration Mutual Funds Generate Returns?
Low-duration funds can generate returns from interest and capital appreciation of the debt securities. Fund managers typically invest part of the assets in bonds with AA or lower credit ratings for improved earnings.
AA ratings indicate that the bond offers a high degree of safety, with low credit risk. But, what do these ratings denote? Why are they important?
Credit rating is the indication of the creditworthiness of an asset. In other words, it denotes the ability of the borrower to pay back the debt in time.
Each credit rating has a letter grade assigned to it (AAA, AA, BB, C or D) depending on the borrower’s creditworthiness.
Bonds with lower credit ratings offer a higher rate of interest. However, with a higher yield comes an increased risk of default.
In the context of mutual funds, yields denote returns. It is the income returned to investors through dividends and interest. Hence, when generating better yields, these funds involve some credit risk.
Such funds can also offer capital gains. For example, suppose the interest rates drop from 6% to 5%. Mutual fund managers may then look to invest in bonds that offer a 6% interest rate.
These have a higher demand because of their capacity to generate better returns. Hence, the bond valuation will rise, thus generating capital gains.
In this scenario, the fund managers want to mitigate the income loss from the drop in interest rates. Generally, they deploy strategies underlined by interests and credit risk to generate yields or returns.
What are the Advantages of Low Duration Mutual Funds?
These funds do not invest in securities with maturities exceeding 12 to 18 months. Hence, the most significant advantage of low-duration mutual funds is their moderate interest rate risk.
There are two main advantages here. When the interest rates drop, the interest income lost on new bonds is lower than the capital gains of the existing bond valuation.
To simplify, if the interest rates go down, naturally, the return will also be lower for newly invested bonds. However, the capital gains generated due to its holding in the existing bonds with higher interest rates will compensate for such income loss.
In the example given above, when the interest rates drop from 6% to 5%, the return generated from investing in the new bonds will be lower.
But, because of the increased demand for the bonds with a 6% interest rate will lead to the increased valuation of the holding, and hence will lead to capital gains.
Typically, these capital gains generated from the existing holding in a bond with a higher interest rate will compensate for the lower income due to the fall of the underlying interest rates.
On the other hand, when interest rates increase, the funds cut down on the maturity period while earning a higher interest rate on new bonds.
Typically, low-duration mutual funds may provide better returns than liquid funds. This difference occurs because low-duration funds have higher duration and risk exposure. In addition, low-duration funds can also potentially outperform ultra-short-duration funds.
They achieve this by generating higher capital gains through investments in debt instruments with longer maturity.
What are the Tax Liabilities on Low Duration Mutual Funds?
Investors can generate capital gains and earn dividend income by investing in low-duration mutual funds. This income generated through dividends is not taxable.
However, capital gains come with tax liability. The tax rate on these capital gains depends on how long we hold the fund’s units.
If we hold the units of a low-duration fund for up to three years, the gains generated will be called short-term capital gains. And they will be taxed as per our respective income tax slabs.
If we hold these units for over three years, the gains will be considered long-term capital gains. Currently, long-term capital gains get taxed at a lower bracket of 20%.
Investing in low-duration mutual funds may expose us to low-quality debt instruments. Such instruments may offer higher returns but come with greater credit default risk. Hence, opt for such funds based on your risk appetite.
Another crucial factor is that fund managers actively manage duration to generate returns. Such actions lead to volatility in the fund’s valuation. Hence, we must conduct thorough risk profiling and assessment before investing.
Most importantly, we must avoid parking contingency funds in low-duration funds.
Investing in low-duration mutual funds comes with its own set of advantages and perks. If we are just starting, we must keep a longer investment horizon and opt for low-duration funds.
This will help us diversify our portfolio. Investing in mutual funds can be a great way to start one’s investment journey.
It offers an entry point into the financial markets with the advantage of professional management.
Explore the best-performing low-duration funds now with Koshex.
Is it safe to invest in low-duration mutual funds?
Low-duration mutual funds offer satisfactory returns within a short duration. Simultaneously, they also carry interest rate and credit default risk. Hence, these funds are moderately risky.
Do low-duration funds have a lock-in period?
Low-duration mutual funds do not have a lock-in period.
Is there an exit on load on low-duration mutual funds?
Each asset management company (AMC) can decide whether to charge an exit load or not. Moreover, the AMCs may also determine the exit load percentage and duration.