What are low duration mutual funds?

Low duration funds are debt mutual funds that invest in fixed income securities with short maturities.

These funds aim to provide a relatively stable return potential by actively managing their portfolio maturity profile and credit risk. Read on to learn more about these funds and the type of investor they may suit.

• Table of contents

1. How do low duration mutual funds work
2. Investment objective for low duration mutual funds
3. Risk profile of low duration funds
4. Return potential of low duration mutual fund
5. Taxation for low duration funds
6. Suitability of low duration mutual funds
7. Advantages of low duration funds

How do low duration mutual funds work

Low duration mutual funds invest in short-term debt securities with a duration of 6-12 months, as per SEBI guidelines. These funds aim to mitigate interest rate risk while generating returns through interest income and capital gains. They may include government securities, corporate bonds, and money market instruments in their portfolio. By holding securities with shorter durations, these funds generally offer relative stability and lower volatility, making them suitable for conservative investors or those looking for relatively stable short-term investments.

Return potential of low duration mutual fund

Low duration funds tend to offer a moderate return potential that depends on prevailing interest rates and market forces.

Taxation for low duration funds

Low duration funds have the same taxation as other debt funds.

Units purchased before April 1, 2023: Gains from units held under 36 months are taxed at the investor's income slab rates as short-term capital gains. Long-term capital gains over 36 months are taxed at 20% with indexation benefits.

Units purchased after April 1, 2023: As per the latest amendment in the taxability of debt, specified mutual funds can no longer avail of the benefit of indexation while calculating long-term capital gains. So, capital gains from debt mutual funds will be taxed at applicable income tax slab rates.

Suitability of low duration mutual funds

Low duration funds may suit the following types of investors:

• Conservative investors: The relatively low volatility and stable return potential make these funds suitable for risk-averse investors.
• Diversification: Low duration debt funds can provide diversification for equity investors to mitigate portfolio volatility and risk.
• Those seeking regular income: Retirees seeking regular income with relative stability of capital can consider these funds.

However, investors seeking very high returns over the long term should consider other funds like equities. Aggressive investors may find the returns of low duration funds limiting.

Investment objective for low-duration mutual funds

By investing in fixed income securities with shorter maturities, low duration funds aim to generate a stable return potential with relatively low volatility. Managing credit risk by investing in high-quality instruments with low chance of default is also an important objective.

Risk profile of low duration funds

Despite the relative stability, low duration funds are not immune to risks. Here are some ways in which they can be affected by market volatility:

Interest rate risk

This refers to the risk of fluctuation of a scheme’s Net Asset Value (NAV) volatility due to changes in market interest rates. When rates rise, existing bond prices typically fall, leading to a decrease in the value of the fund’s assets in the secondary market. This reflects in the NAV. Low duration funds are less sensitive to rate changes due to their short duration, but interest rate risk is not nil.

Credit risk

This is the risk that underlying securities may default on interest and principal payments. Low duration funds usually invest in instruments with high credit quality to mitigate this risk. However, no instruments are risk-free.

Liquidity risk

This refers to the ease with which securities can be sold in the market at desired prices. The relatively short maturity of the portfolio largely mitigates this risk, but low duration funds may face liquidity challenges in certain market conditions.

Advantages of low duration funds

Moderate risk: Low-duration funds seek to offer a balance between risk and return, making them suitable for investors with a moderate risk appetite. They invest in high-quality debt instruments and provide a suitable alternative to savings account and fixed deposits. However, unlike FDs and savings account, the returns are linked to market in case of low duration funds.

Flexible management: These funds invest in securities with maturities between 6-12 months, allowing fund managers to adjust portfolios based on interest rate changes. This flexibility reduces volatility compared to longer-duration funds.

Conclusion

Low duration funds can be a viable fixed income investment option for investors prioritising stability over high return potential. Their strategic focus on short-term maturities and high credit quality helps mitigate volatility and downside risks. These funds may suit conservative investors or those with short-term goals. However, for long-term wealth creation, they may underperform as compared to equity funds and even compared with long term debt funds. They can also be used to diversify and lend relative stability to a portfolio. Evaluate your risk appetite, return expectation and investment horizon before considering these funds.

FAQs

How are these funds different from liquid funds?

While both invest in short-term securities, low duration funds have longer maturity profiles, with a Macaulay duration between 6 months to 12 months, compared to liquid funds that invest in instruments with maturities of up to 91 days.

Are low duration funds riskier than short duration funds?

Both investment avenues carry low-to-moderate risk associated with interest rate sensitivity and credit quality of the underlying instruments.

Difference between low-duration and ultra-low-duration mutual funds

Low-duration funds invest in debt securities with a duration of 6 to 12 months, making them slightly more sensitive to interest rate changes. Ultra-low-duration Funds, on the other hand, invest in securities with an average duration of up to 6 months, making them less sensitive to interest rate fluctuations and relatively stable during volatile market conditions.

Do low-duration funds have a lock-in period?

Low-duration funds do not have a lock-in period. Investors have the flexibility to redeem their investments whenever they choose.

What is the major benefit of investing in low-duration funds?

The major benefit of investing in low-duration funds is the balance they offer between returns and risk. They typically provide relatively better returns than traditional savings accounts while maintaining relatively lower risk than long-duration funds, making them an suitable option for short to medium-term goals. However, unlike savings accounts, returns in case of low-duration funds are not guaranteed.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.