Let's say you're planning a road trip six months from now and want to make some returns from the savings you've put aside for it. However, since you'll need the money soon, you can only afford to take on a little risk.
What should you do? That's where Low Duration Funds come in.
These funds are a type of debt mutual fund that can be an excellent solution for your short-term investment needs. They offer better returns than a savings account or fixed deposit without the high risk of equity investments.
In this guide, we'll cover everything you need to know about Low Duration Funds - how they work, who should invest in them, and how they compare to similar funds. We'll also discuss the factors you must consider before investing in Low Duration Funds in India.
What is a Low Duration Fund?
A Low Duration Fund is a mutual fund that invests in debt and money market instruments. This type of fund has a portfolio with an average Macaulay duration of 6-12 months.
The Macaulay duration measures the average time the fund receives all its cash flows, including interest and principal repayment. A shorter Macaulay duration means the fund is less sensitive to changes in interest rates, making it a safer investment option during periods of interest rate volatility.
How do Low Duration Funds work?
Low Duration Funds invest in debt instruments like treasury bills, corporate bonds, commercial papers, and other money market instruments with a 6-12 months maturity. This makes selling and providing returns to investors more manageable within the same time frame.
The fund manager strategically selects these instruments based on their credit ratings, interest rates, and maturity periods to keep the portfolio's Macaulay duration within the specified range. Low Duration Funds generate returns primarily from the interest income of their debt instruments.
In addition, they can also generate returns from capital appreciation if interest rates fall. However, this is more likely to happen with funds with a suggested investment period of more than 3 years.
When interest rates fall, the prices of existing bonds increase, allowing the fund to sell these bonds at a higher price.
Low Duration Funds vs Liquid Funds vs Overnight Funds
While all three types of funds are short-term investment options, they differ in their investment strategies and risk profiles.
Low Duration Funds invest in debt and money market instruments with a Macaulay duration between 6 - 12 months. They offer moderate returns with moderate risk.
Liquid Funds invest in debt and money market securities with a maturity of up to 91 days. They provide lower returns but are considered one of the safest investment options.
Overnight Funds invest in overnight securities with a maturity of 1 day. They offer the lowest returns but also are the safest option out there.
Who should invest in Low Duration Funds?
Low Duration Funds are suitable for investors who:
Seek better returns than savings accounts or fixed deposits: If you want to maximise your returns while keeping your risk level in check, investing in these funds could be wise. They have the potential to outperform standard savings accounts and fixed deposits, offering a more lucrative return on your investment. Plus, with comparable levels of risk, you can feel confident that your money is in good hands.
Have a short-term investment horizon: Considering low-duration funds can be smart if you have an investment horizon of 6 to 12 months. These funds typically have a portfolio of fixed-income securities set to mature within 6-12 months. This means they have a lower interest rate risk, making them a safer option for investors with a shorter investment horizon. Additionally, these funds tend to have a more stable net asset value(NAV), which provides a more predictable return on investment.
Want to park their surplus funds: If you have extra money and want to earn some returns, investing in these funds can be a good option. They allow investors to make decent returns without taking on too much risk.
Want to diversify their portfolio: Low Duration Funds can diversify your portfolio by providing exposure to different debt and money market instruments and can minimise the overall portfolio risk.
Factors to consider before investing in Low Duration Funds in India
Risks
Although Low Duration Funds are generally less risky than equity funds, they still carry some risk. Some of the risks that they are exposed to are:
Interest Rate Risk: This risk is associated with the potential impact of changes in interest rates on the value of the bonds held in the fund's portfolio. When interest rates increase, the price of the bonds declines, and vice versa.
Credit Risk: This risk is associated with the possibility of the bond issuer failing to meet their payment obligations.
Liquidity Risk: This risk arises when the fund cannot sell a bond quickly enough to prevent or minimise a loss.
Returns
Returns from Low Duration Funds are not guaranteed and depend on the performance of the underlying debt instruments. While these funds may provide better returns than a savings account or fixed deposit, the returns may vary depending on market conditions and the decisions made by the fund manager.
Expense Ratio
Every mutual fund charges a fee to cover its operating expenses, known as the expense ratio. This fee is deducted from your investment and can impact your overall returns.
Therefore, comparing the expense ratios of different Low Duration Funds is essential. A fund with a high expense ratio must generate higher returns to offset the cost, which could be challenging in a low-interest-rate environment.
Investment Plan
Low Duration Funds are suitable for 6 to 12 months. If you have a longer investment horizon, consider other types of funds that can offer higher returns like medium, medium to long or long duration funds.
Taxation of Low Duration Funds
Low Duration Funds are taxed just like any other debt fund. Most of their allocation is towards debt instruments, meaning that investments' gains are subject to taxation based on your income bracket and the tax slab you fall into.
For example, if you made Rs. 1000 in returns on your debt investment and are in the 30% tax bracket, your debt investment would be taxed at 30%, leaving you with a net profit of Rs. 700 after taxation.
Note: Low Duration Funds and other debt funds don't attract long-term capital gains tax, as they aren't considered equity investments. It's crucial to understand that only funds with over 35% equity exposure qualify for long-term capital gains tax benefits, per new tax laws.
Conclusion
Low Duration Funds might be an excellent choice if you're looking for a safe investment option with moderate risk. These funds offer better returns than regular savings accounts or fixed deposits and help diversify your investment portfolio.
However, knowing the risks involved and considering various factors before investing your money is essential.
Dynamic Bond Funds: Frequently Asked Questions (FAQs) FAQs
Should I invest in Low Duration Funds?
Low Duration Funds are suitable for investors who seek better returns than savings accounts or fixed deposits, have a short-term investment horizon, want to park their surplus funds, and want to diversify their portfolio but still want to keep their risk lower than investing in equities.
How do Low Duration Funds compare to Liquid Funds and Overnight Funds?
Low Duration Funds have moderate risks and offer reasonable returns. Liquid Funds have lower risks and returns compared to Low Duration Funds.
Overnight Funds have the lowest returns and risks. Despite this, they are considered one of the safest investment options available.
What factors should I consider before investing in Low Duration Funds?
Before investing in Low Duration Funds, you should consider the risks associated with the fund, the potential returns, the expense ratio, your investment plan, and the diversification benefits of the fund.
Can I lose money in a Low Duration Fund?
While Low Duration Funds are generally considered less risky than equity funds, they are not risk-free. The fund's NAV can fluctuate due to changes in interest rates and the credit quality of the underlying securities and therefore, it's possible to lose money when investing in a Low Duration Fund.
How can I invest in a Low Duration Fund?
You can invest in a Low Duration Fund through a financial advisor, a mutual fund company, or an online investment platform.
