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What are Low Duration Mutual Funds
Low Duration Fund meaning: These are Debt Funds that invest in short-term debt securities, such that the duration of the fund portfolio is between 6 to 12 months. As compared to Overnight or Liquid Funds, Low Duration funds hold assets of longer maturity and/or lower credit quality. Therefore, they have a relatively higher interest rate risk as well as credit risk. However, within the family of duration funds, these are among one of the lowest risk investment vehicles.
The securities held by Low Duration Mutual Funds generally have a maturity period of 6 to 12 months. This Mutual Fund segment has consistently performed well and earned good returns for its investors. Low Duration Funds, thus, continue to attract increasing investments from both retail as well as institutional investors.
They are an excellent avenue for investing in the Indian markets, since they earn through a combination of interest and capital gains on their debt holdings, and generally yield a healthy return of around 7-9%, despite phases of market volatility. Thus, Low Duration Funds offer good returns with a moderate level of risk. It is largely due to their steady and consistent performance, that in spite of the rise of Ultra Short Term Mutual Funds, Low Duration Funds continue to have their own identity and investor clientele. Low Duration Funds are deemed most suitable for investors with an investment horizon of more than six months, investors who have a moderate risk appetite in return for the promise of a regular income, or for those who wish to use them as a medium to route funds into other long-term funds.
How do Low Duration Mutual Funds Work
To understand the working of Low Duration Funds, it is necessary to know what ‘Duration’ means. The duration of a Debt Fund is the attribute that acts as an index of the fluctuations in the fund’s value in response to changes in market interest rates. Thus, the duration can also be considered a measure of the interest rate risk of the fund. So, logically speaking, the higher the duration, the more volatile is the value of the fund, and the greater is the interest rate risk associated with it.
In other words, funds holding debt instruments with long maturity have higher durations as compared to funds whose portfolios are composed of shorter maturity bonds. When a fund increases its holdings of long-term bonds, its duration increases, and along with it, its interest rate risk increases too.
As per SEBI rules, Low Duration Funds are required to maintain fund duration between 6‐12 months. This necessarily means that Low Duration Funds invest entirely in short-term debt securities and in turn, means that these funds carry relatively low-interest rate risk.
Even within the limits of short-term debt instruments, Low Duration Funds have a wide choice available for portfolio investment, including money market securities, government securities, corporate bonds, securitized debt, hybrid instruments like REITs, permitted derivatives, or even other Mutual Fund units.
The earnings from Low Duration Funds are through the twin avenues of interest and capital gains on their debt securities. It, therefore, follows that Low Duration Funds employ strategies involving credit risk as well as interest rate risk to generate higher returns for their investors.
Most Low Duration Funds actively court a small amount of credit risk with an eye to higher returns. In order to boost their interest earnings, most Low Duration Funds make it a practice of holding a part of their assets in bonds with credit ratings of AA or lower, which carry a bit of risk but pay relatively higher interest rates.
Since Low Duration Funds also generate capital gains, fund managers sometimes increase holdings of longer maturity bonds when interest rates are falling, in a bid to push up the value of the fund. The consequent gain in the capital value of existing bonds more than counterbalances the loss of interest income incurred by investing fresh inflows at lower interest rates.
Advantages of Low Duration Funds
The reason that Low Duration Mutual Funds are considered one of the most attractive investment instruments is that they come with definite benefits over other investment vehicles.
Moderate Risk: Since Low Duration Funds offer reasonably high earnings in return for a moderate level of risk, they are an attractive investment proposition for investors with a moderate risk appetite and a great alternative to savings and fixed deposits. Further, as most of these funds hold reasonably good quality debt instruments, they are found suitable by investors with a moderate risk appetite.
Low Duration Funds usually hold securities that have maturity periods between 6-12 months, generating earnings from both interest and capital gains, and this puts them in a position of advantage. When interest rates fall, the loss of interest income on fresh bonds is much lower than the capital gains on the value of existing bonds.
Conversely, when interest rates increase, the fund managers opt for cutting back on duration to minimize capital losses, at the same time, earning higher interest rates on new bonds. Due to this possibility of flexible portfolio management, the value of Low Duration Funds is less volatile as compared to longer-duration funds.
Higher Returns: Low Duration Funds are usually observed to outperform Liquid Funds because they are allowed greater leeway under SEBI rules, to take on greater credit and duration exposure. Low Duration Funds also have the capacity to make higher capital gains by holding longer maturity bonds. They thus have the potential to perform even better than Ultra Short Duration Funds. In terms of real-life performance, most good Low Duration Funds have been observed to yield a consistent rate of return between 4 and 5%, which is extremely attractive.
Taxes on Low Duration Funds
Earnings from Low Duration Funds come in the form of dividend income from the interest on securities held by the fund, and from capital gains on the portfolio holdings. Dividend income is not taxable for investors. However, capital gains, i.e., the difference between the purchase price and selling price of the units, is taxable. The taxation rate on capital gains depends on how long the investor has held the units of the Low Duration Fund.
In case of the investor holding the units of the fund for up to three years (36 months), the capital gains incurred upon redemption are considered as short‐term capital gains and taxed at the income tax slab rate applicable to the investor.
If, however, an investor redeems their units of a Low Duration Fund after more than three years, then the difference between the purchase and sale price of the units falls under the purview of long-term capital gain. In this case, the investor is allowed the benefit of ‘indexation’. Thus, before calculating the capital gain, the purchase price is adjusted for inflation on the basis of an index provided by the government. The taxable amount is, thus, invariably reduced due to indexation. Long-term capital gains are currently taxed at a uniform rate of 20% along with indexation benefits.
Who Should Invest in Low Duration Funds
The investor profile for Low Duration Funds ideally comprises those who are looking for a regular income, or for alternatives to savings accounts and fixed deposits, with an investment horizon of more than six months. These funds are also a useful place from which investors can route their money into longer-term Equity Funds via the Systematic Transfer Plan (STP) arrangement.
- Regular Income: Since Low Duration Funds have the potential to generate a regular income through a combination of interest earnings and capital gains, investors with a moderate risk appetite can invest a judicious portion of their total investible amount in these funds and create a stream of regular income flows through Systematic Withdrawal Plan (SWP).
- Alternative to Bank Deposits: Low Duration Funds are an attractive option for investors with a moderate risk appetite, since they are generally a more lucrative alternative to parking their short term funds in bank deposits, since they offer a high level of liquidity along with higher returns.
- Investment Horizon of 6 Months or More: Low Duration Funds are the ideal option for an investment horizon of six months or higher. For holding periods longer than six months, Low Duration Funds offer higher returns with a very small incremental risk. For such investors it makes excellent sense to go for Low Duration Funds to temporarily park funds such as surpluses from the sale of a property, annual bonus, saving towards a short-term financial goal, etc.
- Routing Investments to Equity Funds: Low Duration Funds can be used as a repository by moderate risk investors, while using an STP to route investments into an Equity Fund or Hybrid Fund.
Things to Consider Before Investing in Low Duration Funds
The primary concerns with investing in Low Duration Funds are credit risk due to portfolio composition, and interest rate risk due to market volatility.
Since these funds may have significant exposure to low‐quality debt in a bid to increase dividends, a large default can cause fund value to drop sharply. Further, Low Duration Funds actively juggle portfolio duration in response to interest rate fluctuations, in order to generate better returns. The value of these funds is, thus, subject to some volatility.
Low Duration Funds should, thus, be evaluated in terms of return, risk, and expense ratio.
- Return: The performance of a Low Duration Fund may be reasonably assessed on the basis of 6-month or 1‐year returns, since they primarily invest in short term debt. A well-performing Low Duration Fund should be able to outperform both, its benchmark as well as the returns earned by comparable funds. Additionally, the best performing funds consistently earn good returns. Therefore, investors need to make a longer-term scrutiny of the returns generated by the funds in previous years before deciding to invest.
- Risk: Since Low Duration Funds carry both interest rate risk and credit risk, a prudent investor needs to track the duration of the fund, which is published each month. The changes in duration over a period of time reliably indicate whether the fund has increased its interest rate risk. The investor also needs to evaluate the portfolio composition in terms of the credit quality of the fund’s holdings and tally it with their personal risk appetite, since a significant proportion of a Low Duration Fund’s assets being invested in lower-rated debt spells a higher risk of default.
- Expense Ratio: The Expense Ratio, or the annual amount charged by a fund for managing its portfolio, is deducted from the earnings while calculating net return to the investor. Even though Low Duration Funds generally have low expense ratios, it is important to keep track of this parameter since it impacts the final return to the investor.
Frequently Asked Questions (FAQs)
1. Is it Safe to Invest in Low Duration Mutual Funds?
While Low Duration Mutual Funds generally earn a good rate of return with a high level of liquidity, they carry a higher risk than Liquid and Ultra-short Duration Funds. The risk derives from their relatively longer lending duration. Thus, they may sometimes lend to risky borrowers to bolster their returns – a manoeuver that comes with a default risk. Low Duration Funds are, therefore, for the moderate-risk investor.
2. Do Low Duration Funds have a Lock-in Period?
No. Low Duration Funds do not have a lock-in period, which is why they offer a high degree of liquidity to the investors.
3. Do Low Duration Funds have an Exit Load?
There is no rule that specifies the parameters of exit load on Low Duration Funds. It is left entirely to the discretion of the fund houses, whether or not they charge an Exit Load, and if they do, what percentage and for what period. This is another aspect that investors need to investigate before investing.
4, Difference between Low Duration and Ultra-Low Duration Mutual Funds
The difference between Low Duration Funds and Ultra-low Duration Funds is the tenure for which these funds invest in debt instruments. While Ultra-Low Duration Mutual Funds invest for a period of up to six months, Low Duration Funds may lend for up to a one-year period.
