Introduction
According to the Securities and Exchange Board of India (SEBI), there are 16 types of debt instruments. The categorization was carved out to provide investors with multiple options and make investments easier and simpler. Moreover, these categories also consider the investment strategy and the tenure of the instrument. Hence, SEBI classifies debt funds depending on their investment tenure as, long duration funds, Low duration funds, Liquid funds, Overnight funds, etc. The article's objective is to learn and understand the concept of low duration mutual funds, how they function, their risks and returns, and more. So, let's dive right in!
What are Low Duration Mutual Funds?
Primarily, low duration mutual funds are a type of debt mutual fund. According to the SEBI guidelines and categorisation, these funds should invest in debt and money market instruments. Also, the overall Macaulay duration of the investment should range from six months 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).
Investment in low duration mutual funds is most suitable for investors with a lower-risk profile and an investment horizon of around one year. Low-duration funds provide a greater maturity than the average liquid or overnight funds. However, they have lower returns than long, medium, and short duration mutual funds. Investing in low duration funds will allow you to park your money in the debt market for six to 12 months and generate greater interest than a regular savings account. Typically, such funds offer returns in the range of 6.5% to 8.5%.
How Low Duration Funds Operate?
We know that low duration funds have an investment tenure of about a year. However, to understand the functioning of low duration funds, it is essential that we grasp the concept of "duration" as it affects the investment decisions as well as returns generated from the same.
What is Duration?
In debt mutual funds, duration refers to the measure of the fluctuations in the fund valuation with respect to the changes in the interest rates. Hence, duration is also called the interest rate risk. As the duration increases, so does the interest risk, making the fund value more volatile. For investors, a general rule can be to calculate the duration based on the bond maturity period held by the mutual fund. Mutual funds investing in long-maturity bonds generally have higher durations compared to the ones with shorter maturity periods. When a fund increases its investment or holding in long-term bonds, there is an increase in the duration of the fund.
What are the Investment Avenues for Low Duration Funds?
Low-duration 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. There are no restrictions on these funds to invest in a particular type or the credit quality of the debt instruments.
What are the Sources of Earnings for Low Duration Funds?
Low duration funds can also generate returns from interest and capital appreciation of the debt securities. These funds can improve earnings by investing part of their assets in bonds with AA or lower credit ratings. Typically, these bonds offer a higher rate of interest. However, with a higher yield, the investment may also attract an increased risk of default. Generally, these low duration mutual funds will bear some credit risk to generate better returns.
Moreover, such funds can also offer capital gains. When there is a drop in the market interest rates, the mutual fund managers can choose to raise the exposure of the bonds with longer maturity. This leads to an increase in the bond valuation and hence the capital gains. The fund managers' aim is to mitigate the loss of income due to the fall in interest rates. Generally, they deploy investment strategies based on both interests as well as credit risk in order to generate yields.
What are the Advantages of Low Duration Funds?
One of the most significant advantages of investing in low duration funds is that it offers moderate interest rate risk. This is due to the fact that these funds do not invest in securities that have maturities longer than 12 to 18 months. Such an investment strategy offers a dual advantage. During the downward trend of interest rates, the loss of interest income on new bonds is lower compared to the capital gains of the existing bond valuation. On the other hand, when interest rates are increasing, the funds cut down on the maturity period while earning a higher interest rate on fresh bonds.
In terms of general comparison, low duration mutual funds may provide better returns than liquid funds. One of the key reasons behind the outperformance is the ability of these funds to take higher duration and credit exposure. In addition to this, the low duration funds can also potentially outperform ultra-short-duration funds by generating higher capital gains through their holdings in longer-maturity debt instruments.
What are the Tax Liabilities on Low Duration Mutual Funds?
As an investor, you can generate capital gains as well as earn dividend income through your investments in the low duration mutual funds. The income generated through dividends is not taxable. However, the capital gains fall under tax liability. Capital gains are the difference between your buy and selling prices. The tax rate on these capital gains depends on how long you hold the units of the fund.
If you hold the units of a low-duration fund for up to three years, the gains generated will be termed short-term capital gains and will be taxed as per your income tax slab. If you hold these units for over three years, the gains will be considered long-term capital gains. Currently, long-term capital gains are taxed at a lower bracket of 20%.
Things to Consider Before Investing in Low Duration Funds
One of the primary aspects to consider while investing in low duration funds is you may be exposed to low-quality debt instruments. Such instruments may offer higher returns but come with greater credit default risk. Another important factor to consider is that fund managers actively manage duration to generate returns. Such management may lead to volatility in the fund's valuation. Hence, conducting a thorough risk profiling and assessment before investing is always advisable. Another rule to follow is to avoid parking contingency or emergency funds in low duration funds. Explore the best performing low duration funds here.
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