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?
- Advantages of Short Duration Debt Funds
- What are long duration debt funds?
- Advantages of 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.
Advantages of short duration debt funds
Short duration debt funds can be a suitable avenue for investors seeking better return potential than traditional avenues and more stability than aggressive market-linked instruments. Some of the advantages of these funds are:
1. Relatively stable returns: Short-duration debt funds primarily invest in fixed-income securities with shorter maturities, reducing their exposure to interest rate fluctuations. This makes them relatively stable compared to long-duration funds, especially during periods of rising interest rates.
2. Lower interest rate risk: The shorter maturity profile mitigates the impact of interest rate changes on the portfolio. As a result, these funds are less sensitive to rate volatility than longer duration fund, making them suitable for more conservative investors or short-term investors.
3. Liquidity: Short-duration debt funds generally provide high liquidity, making them suitable for investors who might need access to their funds in the near to medium term.
4. Professional management: Fund managers' expertise helps mitigate risk and optimise return potential. The fund managers may do this by:
- Conducting comprehensive financial analysis of issuer entities
- Monitoring material events continuously
- Performing due diligence before security selection
- Implementing proactive risk assessment and management strategies
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.
Advantages of long duration debt funds
Here are some of the advantages of long duration debt funds:
1. Higher liquidity than fixed deposits: Unlike fixed deposits, debt funds offer greater liquidity. Investors can redeem all or part of their units, or top up their investments, providing easy access to funds.
2. Reasonable return potential: Long-duration funds can potentially deliver similar or better returns than fixed deposits of a similar tenure, especially in a falling interest rate environment. However, unlike fixed deposits, they do not guarantee fixed returns or capital stability. They can also offer better return potential than debt funds with shorter maturity profiles.
3. Portfolio diversification: Including debt mutual funds in your investment strategy helps diversify your portfolio to mitigate risk.
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.
Which is more expensive: short term or long-term investment?
The cost of an investment (short-term or long-term) depends on several factors, including transaction fees, taxes, and the opportunity cost of funds, rather than being inherently tied to the length of time you hold it.
1. Short-Term Investments
- Tax Implications: Gains are often taxed at the higher short-term capital gains rate.
- Volatility Costs: Short-term investments in equity or other high-risk avenues are more exposed to market fluctuations, potentially leading to lower returns.
2. Long-Term Investments
- Tax Advantages: Long-term capital gains are typically taxed at a lower rate than short-term gains, making them more tax-efficient.
- Opportunity Costs: Your funds are tied up for longer, so there may be missed opportunities for other investments or immediate use.
- Inflation Risks: Over the long term, inflation can erode purchasing power, which is a hidden cost of holding investments like cash or bonds.
The ultimate "cost" also depends on your goals, strategy, and risk tolerance. If you need quick liquidity or aim for speculative profits, short-term investing may make sense, even if it's costlier. For wealth accumulation potential with mitigation of volatility risk, long-term investing may be better.
What are the disadvantages of short-term investing?
Short-term investing is suitable if done in relatively stable avenues and for short-term goals. If you make a short-term investment in a more volatile avenue (such as equities or long-duration debt funds), you may make quick profits in favourable market conditions but the chances of loss are significantly higher. Moreover, the psychological stress of market volatility, high risk to invested capital and higher taxes (in the case of short-term capital gains on equity funds) can be significant drawback.
How many years are considered long term investing?
Long-term investments are typically those held for over five years, though the definition can vary from context to context.
Where do short-duration mutual funds allocate their investments?
Short-duration mutual funds can invest in money market instruments like CPs, CDs, T-bills, as well as short-term government and corporate bonds. They have short maturities, lower interest rate risk, higher liquidity and reasonable return potential.
How long should one remain invested in long-duration mutual funds?
Long-duration mutual funds suit investors with medium to long investment horizon. These funds are sensitive to interest rate changes, but long-term investors can potentially weather these fluctuations. Align your goals and risk tolerance, prepare for market volatility, and review your portfolio regularly.
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.