Medium duration mutual funds: Definitions and key benefits

The recent volatility in global markets have made investors the world over seek out relatively stable avenues for their funds. In such uncertain times, an investment opportunity that may be suitable is a debt mutual fund.

There are multiple categories of debt mutual funds in India, based on the portfolio duration or the types of assets they invest in. One such category is medium duration mutual funds. These funds, as indicated by their title, invest in bonds or debt instruments that have a medium duration, typically three or four-year time frame. Their investment objective is to provide a return potential that is relatively higher than short-term instruments, but with lower volatility than longer duration investments.

This article tells you more about what are medium duration funds, including medium duration funds meaning, investment strategies and who such funds may be suitable for.

• Table of contents

• Defining medium duration mutual funds
• How medium duration mutual funds work
• Medium duration funds practical example

Defining medium duration mutual funds

Medium duration mutual funds (sometimes informally called “medium-term bond funds”) focus on medium-term debt instruments. While the maturity of each debt instrument may vary, the Macaulay duration of the portfolio should be between three and four years, as per regulatory guidelines.

Macaulay duration is a way to measure how long it takes on average for an investor to get back all the money they invested in a bond, considering both the regular interest payments (coupons) and the final principal repayment. This metric helps investors understand interest rate risk. Typically, when it comes to debt instruments, the higher the duration, the more sensitive the bond is to interest rate changes.

Macaulay duration indicates a fund’s sensitivity to interest rate changes in the economy. Generally, when interest rates fall, the market value of existing bonds with higher coupon rates rises, raising the fund’s NAV. If interest rates rise, the value of existing bonds tend to fall. The higher the security’s duration, the greater is the interest rate risk.

So, a medium duration mutual fund is higher risk than shorter duration funds, but with better return potential. At the same time, they are lower risk than long duration funds.

By confining themselves to a medium-term bracket, managers look to capture reasonable interest income potential while mitigating interest rate risks.

Medium duration funds can hold a mix of corporate bonds, government securities, or money market instruments. While interest rate shifts still affect their net asset values (NAV), the medium horizon may cushion some volatility.

Also Read: What are mutual fund units?

How medium duration mutual funds work

Medium duration mutual funds are professionally managed. Money from a large group of investors is pooled together. The fund manager then invests this in a portfolio of debt securities selected based on their credit quality, interest rates, types and other factors. The securities have to be selected such that the Macaulay duration of the portfolio is three-four years.

Here are some aspects of the fund’s working:

• Interest/coupon collection: The fund regularly collects coupon payments from the bonds it holds.
• Reinvestment: Coupons may be reinvested to buy more debt securities, compounding potential returns.
• Adjusting portfolio: The manager might replace or rebalance securities based on market conditions to maintain the required portfolio duration.

Medium duration funds practical example

Suppose a mutual fund invests primarily in a basket of corporate bonds each maturing in about three years. By year two, some bonds may approach maturity, prompting the manager to add fresh three-year instruments to maintain the fund’s typical duration. Through this constant renewal, the fund remains a “rolling” medium-duration product. Investors can remain in the fund indefinitely, but the underlying bond positions revolve every few years to preserve that targeted maturity window.

Investor suitability

Who should invest in medium duration mutual funds? Such funds may be suitable for:

• Investors with a moderate risk appetite: Willing to handle mild fluctuations for better yields than short-term bank FDs or money market funds.
• Mid-term goals: Investors with a horizon of 3–5 years.
• Reluctant about equity: Looking for returns above short-term debt but not wanting the volatility associated with equities.
• Comfortable with some rate sensitivity: If interest rates surge, the fund’s NAV could dip, though less severely than that of a long-term bond fund.

Picking suitable schemes

Here are some factors investors should consider when choosing a medium duration fund:

• Credit quality: A fund with lower-rated corporate bonds might offer higher potential yields but with greater default risk. Confirm the average credit rating.
• Historical performance*: Evaluate the fund's past returns (if available). Checking returns over multiple cycles helps assess the fund’s consistency. *Past performance may or may not be sustained in future.
• Expense ratio: The difference in fees can erode net returns. Generally, lower expense ratios benefit investors.
• Fund manager track record: A skilled manager with experience in debt investing may be able to better navigate the interest rate environment.

Crucial factors before investing

• Interest Rate Environment: If rates look set to rise significantly, medium duration funds might see short-term NAV dips, though less than longer duration instruments.
• Tax implications: Potential profits from debt funds are taxed as capital gains at the time of redemption. All gains are added to the investor’s taxable income and taxed at applicable slab rates.

Contrasting with equities

Comparing medium duration funds vs. equity market clarifies each approach:

• Volatility: Equities can fluctuate more, especially over short or medium timelines. Medium duration debt funds are less volatile, though not risk-free.
• Returns: Historically, equity tends to outperform debt securities in the long term*. However, they also carry higher risk. Investors with a short-or-medium term horizon may prefer debt funds for their relatively stable return potential. *Past performance may or may not be sustained in future.
• Risk tolerance: Younger or more aggressive investors might embrace equity fluctuations for higher potential gains over time. More conservative individuals or those with shorter term goals may find medium duration funds more suitable.
• Portfolio mix: Many investors blend equity mutual funds with medium duration debt funds to strike a balance between growth potential and relative stability.

Also Read: What is a mutual fund

Conclusion

In uncertain interest rate climates, or simply as part of a diversified strategy, medium duration mutual funds can offer a relatively stable investment solution with higher return potential than short-term debt funds and lower risk than long-term ones. By reviewing the medium duration funds meaning, you can see how these funds might offer the potential for relatively stable returns while potentially mitigating overall risk in a portfolio that also comprises equities.

FAQs:

Which mutual fund is best for the medium term?

No mutual fund can be termed ‘best’ but for mid-term goals (3–5 years), medium duration funds can be a suitable choice. They’re not as volatile as longer bond funds or equity, but typically offer better return potential than short-term debt instruments.

What is the duration of a medium term investment?

While definitions vary, many consider 3–5 years as a medium-term horizon. Specifically, medium duration funds have a portfolio Macaulay duration of 3-4 years.

What is medium duration fund?

It’s a debt mutual fund primarily investing in bonds or instruments such that the Macaulay duration of the portfolio three to four years. This approach balances return potential with moderate interest rate risk.

What is a medium term SIP?

A medium-term SIP (Systematic Investment Plan) may refer to an investment strategy where you invest a fixed amount in mutual funds regularly for a period of around 3 to 5 years.