Short duration vs. long duration debt funds: How to choose?

Navigating the world of investing can sometimes feel like learning a new language. However, once you familiarise yourself with some basic concepts, the rest of the journey can become easy and smooth.

One such concept that might seem puzzling to investors at first is that of duration. This concept is crucial for investments in fixed income investments and can help investors decide what sort of fund to choose based on their investment objectives and risk appetite.

This article tells you more about duration, especially focusing on short duration debt funds, long duration debt funds, and the difference between the two.

Table of contents

What is duration?
What are short duration debt funds?
What are long duration debt funds?
Difference between short duration vs. long duration debt funds
How to choose between short duration and long duration debt funds

What is duration?

Duration is a key metric in fixed income investing and indicates the sensitivity of a bond to interest rate changes. There are two main types of duration measures: Macaulay duration and modified duration.

Macaulay duration measures the time it will take for the principal of a bond to be repaid from the internal cash flows (both interest and principal) generated by the bond. Modified duration, meanwhile, measures how much a bond's price will change with a change in interest rates.

Both measures indicate the sensitivity of a bond’s value to interest rate changes in the economy. Generally, when interest rates fall, the value of a bond rises, and vice versa. This is known as interest rate risk. This change in value can lead to a corresponding increase or decrease in the net asset value (NAV) of a debt mutual fund.

The longer the duration of a fixed income instrument, the higher the interest rate risk. This is because there is a greater time period over which interest rate changes can affect the bond's price.

What are short duration debt funds?

Short duration debt funds are investments that target short-term financial instruments like bonds and other debt securities with a Macaulay duration of one to three years.

The shorter investment period of these funds makes them less sensitive to interest rate fluctuations compared to longer-term bonds. This makes them a relatively stable option for investors seeking modest return potential. For instance, they can be a suitable avenue to invest money for short-term goals such as a big purchase. It can also be used to build an emergency corpus or to park surplus funds and receive better potential returns than a savings account.

They can also be a part of a diversified investment strategy, adding relative stability to a portfolio that also has equity investments for greater growth potential.

What are long duration debt funds?

As the name suggests, long duration debt funds primarily invest in bonds and securities that mature over an extended period. The Macaulay duration of the portfolio is seven years or more. Long duration debt funds typically put money into long-term government and corporate bonds, as well as other financial instruments that are expected to yield returns over many years.

The primary advantage of investing in long duration debt funds is the opportunity for higher returns in return for the increased risk. This includes greater exposure to interest rate volatility (interest rate risk) as well as credit risk, which is the chance that a bond issuer may fail to fulfill their financial obligations.

This makes such funds suitable for investors who have a long investment horizon and are willing to incur some risk for potentially higher returns. Generally, it is recommended that investors align their investment horizon with the portfolio duration of a debt investment, to mitigate the impact of short-term fluctuations in bond prices on the investment value.

Difference between short duration and long duration debt funds

Understanding the key distinctions between short duration and long duration debt funds can help you choose the right investment based on your financial goals and risk tolerance.

Criteria	Short duration funds	Long duration funds
Portfolio composition	Invest in debt securities with a portfolio Macaulay duration of one to three years.	Invest in debt securities with a portfolio Macaulay duration of seven years or more.
Interest rate sensitivity	Less sensitivity because of the short duration of the portfolio	Greater sensitivity because of the longer duration of the portfolio
Risk	Relatively lower because of the shorter maturity periods.	Higher risk because of longer exposure to market conditions and greater interest rate sensitivity.
Return potential	Lower than that of long duration funds.	Higher in exchange for increased risk.
Suitable for	Conservative investors looking for a short-term investment avenue.	Investors seeking higher return potential than traditional savings avenues with lesser risk than equities.

How to choose between short duration and long duration debt funds

Deciding whether to invest in short duration or long duration debt funds largely depends on your financial goals, investment timeline, and risk tolerance.

Consider your investment timeline:
- Short duration funds may be suitable for short-term goals such as a home renovation, travel funds or a car purchase.
- For long-term financial goals such as retirement planning, long duration funds can be a stabilising element in a diversified portfolio that also comprises equities.
Assess your risk tolerance:
- Short duration funds are relatively more stable than long duration funds, with less price volatility. This makes them suitable for those who have a conservative investment approach but seek better return potential than savings accounts and traditional avenues.
- Long duration funds, while potentially more profitable, also come with higher risks, especially from interest rate fluctuations. They are better suited for those who can handle periods of market volatility.
Evaluate return expectations:
- Short duration funds can be suitable for those who are comfortable with a lower return potential in exchange for more stability.
- If you aim for higher returns and are willing to accept the associated risks, long duration funds offer higher growth potential.

Conclusion

When deciding between short duration and long duration debt funds, it's best to align your choice with your financial goals, timeline, and risk tolerance. Short duration funds offer relative stability and are suited for near-term objectives, while long duration funds offer higher return potential than short duration debt funds with greater risk. They are also suitable for a longer investment horizon. By understanding these key differences, you can make an informed choice that not only meets your immediate financial needs but also supports your long-term financial health. To gauge the potential returns on your investments in these funds, you can use an SIP return calculator.

FAQs

What is a debt mutual fund?

A debt mutual fund is an investment vehicle that pools money from multiple investors to invest in fixed-income securities such as bonds, treasury bills, and commercial paper. These funds are managed by professional fund managers and aim to provide regular income and mitigate impact on capital invested. Debt mutual funds are generally less risky than equity mutual funds, as they invest in relatively stable instruments. They are suitable for investors seeking steady returns with lower risk. The performance of these funds depends on interest rate movements, credit quality of the securities, and overall economic conditions.

Which one is better, short-term or long-term investment?

The better option depends on your financial goals, risk tolerance, and investment timeline; short term investments are better for relative stability and short-term goals, while long term investments are suited for higher returns over a longer period.

Why is long-term investment better than short-term investment?

Long term investments can be better because they offer the potential for higher returns, taking advantage of compounding interest and market growth over time.

Which is riskier, short or long-term investing?

Long term investments can be riskier due to their higher sensitivity to market fluctuations and interest rate changes. However, they also offer higher return potential in exchange for this increased risk.