Low Duration Funds

What Are Low Duration Funds?

Securities and Exchange Board of India (SEBI) recategorised mutual fund schemes in 2017. Three major categories were created- Equity funds, Debt funds, and Hybrid funds. The idea was to ease investor decision-making as many mutual fund companies had introduced many schemes. 

The best low duration funds majorly invest in debt securities with a shorter time frame. In actual finance terms, duration is a complex concept. It is safe to assume that funds that invest in bonds with shorter maturity are low-duration funds. According to SEBI's classification, low duration funds invest in securities that mature within 6-12 months. 

Who Should Invest in Low Duration Funds?

Retail investors usually invest with a financial goal in mind that should be fulfilled at the maturity of the fund. For example, a father may begin setting aside money every month for his child's higher education ten years from today. Investing with a goal in mind helps determine the investment horizon and the risk that the investor can take. Investors' best low duration funds are funds with a shorter investment horizon and a lower risk preference. 

The risk of low duration funds is lower than high duration funds and higher than ultra-low duration funds. As the duration of a fund increases, the interest rate risk associated with it also increases. Interest rate risk is fluctuations in low duration funds return due to changes in market interest rate.

So, in essence, low duration funds are perfect for an investor who has short-term financial goals. For example, a salaried employee wants to save little by little for an abroad vacation next year. They can start a Systematic Investment Plan (SIP) today with that aim. They can invest in low duration fund as it fits his investment horizon of 12 months.

In addition to investment horizon and risk profile, investors for low duration funds can also be determined using individual factors like idle funds. For example, an individual has idle funds that need to be used elsewhere after seven months. They can invest it in low duration funds instead of a Fixed Deposit that gives a lower return.

Features of Low Duration Funds

  • The best low duration funds invest in debt securities like money market instruments, bonds, G-Secs (government securities), etc.
  • The fund can be open-ended or close-ended. Open-ended funds allow entry and exit to investors throughout the fund’s life until maturity.
  • The income on debt instruments is the coupon or regular income monthly, quarterly, semi-annually, or annually.
  • Apart from investors with a lower investment horizon and lower risk profile, low duration funds are also suitable for investors who require a regular source of income from their investment.
  • Funds with a shorter duration will be more liquid than funds with a longer duration.
  • Low duration funds do not require constant management by the fund manager. Once the instruments to be invested in are selected based on value, income flows, and credit quality, the need for active management reduces greatly.
  • These funds usually have lower fund management fees.

Taxability of Low Duration Funds

Most investors think of tax benefits when investing in the best low duration funds. Mutual funds can be taxed based on their gains. Gain on selling a mutual fund scheme is classified into two types- Short Term Capital Gains and Long-Term Capital Gains. Gains depend on the holding period. The minimum holding period of a debt mutual fund as per tax rules of India is three years. 

It means that if an investor sells the fund within three years of purchase, it will be taxed as Short Term Gain. Let’s take an example to understand this better. Suppose someone purchased a Low duration Fund on 01 March 2020 and sold it on 01 March 2022. Since the holding period is two years, it is Short term capital gain and will be taxed as per the investor’s applicable tax slab. Long-Term Capital Gains held for more than three years are taxed at 20%.

Risk Involved With Low Duration Funds

Interest Rate Risk

Interest rate risk exists in all types of debt funds, although at different levels. Interest rate risk is the risk that changes the fund’s value due to changes in market interest rates. Debt funds invest in debt instruments. The return from debt instruments is interest on the amount invested. If the market interest rate decreases, there are high chances that interest return from these debt instruments that the fund has invested in will also decrease. Since return decreases, the overall value of the fund also decreases.

Credit Risk

Credit risk is the risk that one of the debt holdings that a fund has invested in will default. This may lead to a decrease in the value of the fund. The amount of credit risk of a fund depends on the credit rating of instruments it invests in. Debt instruments with higher credit ratings have lower chances of default. The average credit ratings of instruments invested are usually mentioned in the fund’s summary. Hence, one may find statements like “This fund invests in instruments with a rating of BBB and more” in the details of the fund.

Advantages of Low Duration Funds

Liquidity

Since low duration funds invest in debt instruments with lower maturity than high duration funds, the liquidity of these funds is also higher.

Low risk

Interest rate risk for low duration bonds is comparatively lesser. It takes time for changes in market interest rates to penetrate the market. Hence, it does not impact low duration instruments to a great extent compared to funds with higher duration.

Decent returns

The annualised low duration funds returns are better than that of the ultra-short-term fund. This can be illustrated with a real-life example. The 3-year return (annualised) of HDFC Ultra Short Term Fund Direct-Growth is 5.93%. On the other hand, the 3-year return (annualised) of HDFC Low Duration Fund Direct Plan-Growth is 6.9%. Thus, a theoretical point is explained with a real-life example. These funds give better returns to invest for a greater time horizon.

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