What Are Low Duration Mutual Funds? Meaning, Types, and Returns

Want to invest in mutual funds but wary of long-term investment? Low duration funds may be right for you.
Low duration Mutual Funds
4 mins
22 December 2023

Mutual funds are a popular way of investing money in the financial markets. They offer the benefits of diversification, professional management, and liquidities. There are many categories of mutual funds, which differ in terms of their risk, return, and investment horizon.

One such category of mutual funds is low duration funds. In this article, we will explain what low duration mutual funds are, how to invest in them, how they work, who should invest in them, how they are taxed, and what to consider before investing in them.

What are low duration mutual funds?

Low duration mutual funds are a type of debt funds that invest in debt and money market instruments with a maturity of 6 to 12 months. The average duration of the portfolio is between 6 to 12 months.

Low duration funds aim to provide stable returns with low volatility and low risk. They are suitable for investors who have a low risk appetite and a short term investment horizon.

How to invest in low duration funds

Investing in low duration funds is easy and convenient. You can invest in them through online platforms, such as mutual fund websites, apps, or portals. You can also invest through offline modes, such as visiting the nearest branch of the fund house or through an agent or distributor. You can invest in low duration funds either as a lump sum or through a systematic investment plan (SIP).

A lump sum investment is when you invest a large amount of money at once. SIP is when you invest a fixed amount of money at regular intervals, such as monthly or quarterly.

How do low duration mutual funds work?

Low duration mutual funds work by investing in debt and money market instruments with a maturity of 6 to 12 months. These instruments include corporate bonds, commercial papers, certificates of deposit, treasury bills, and so on. These instruments offer higher returns than bank deposits, however, they also carry a higher level risk.

Low duration funds aim to generate income and capital appreciation by holding the securities till maturity or by trading them in the secondary market. The fund manager decides the allocation of the portfolio based on the market conditions, the credit quality of the issuers, and the liquidity of the instruments. The fund manager also monitors the performance of the portfolio and makes changes as and when required.

Who should invest in low duration funds?

Low duration funds are ideal for investors who have a low risk appetite and a short term investment horizon. They are suitable for investors who want to park their money for short period only and earn higher returns than bank deposits. They are also suitable for investors who want to invest in debt funds but are wary of the interest rate risk.

Low duration funds offer stability and predictability of returns with low volatility and low risk. They can also be used as a part of the asset allocation strategy to balance the risk and return of the overall portfolio.

Advantages of Low Duration Funds

  • Balanced Risk: Low-duration funds come with a moderate level of risk related to changes in interest rates, as they typically invest in securities with maturities up to 1-1.5 years. This places them in a favorable position: during interest rate declines, the loss of interest income on new bonds is much less than the gains on existing bond values. When interest rates rise, these funds reduce their investment duration to minimise potential losses while earning higher interest rates on new bonds. Consequently, the value of low-duration funds tends to be less volatile compared to funds with longer durations. Since the 2018 NBFC crisis, investors have expressed concerns about credit risk, but many low-duration funds hold debt of reasonably good quality, making them suitable for investors with a moderate risk tolerance.
  • Enhanced Returns: Low-duration funds often outperform liquid funds due to their ability to take on more credit and duration exposure. They also have the potential to surpass ultra-short-duration funds by generating higher capital gains through the holding of longer-maturity bonds.

Risks Involved While Investing in Low Duration Mutual Funds

When considering and investing in the best low duration mutual funds for your investment portfolio, it is essential to be aware of certain risks associated with them. Firstly, these funds might have exposure to low-quality debt, which can lead to a decline in the fund's value. Investors may face the dilemma of selling at a loss or holding onto units at a reduced value. Secondly, as actively managed funds, low duration funds are subject to volatility, impacting the fund's value. Lastly, investors should be mindful of interest rate risk, ensuring it aligns with their risk tolerance and financial objectives. Being aware of these risks is crucial for making informed investment decisions in low duration mutual funds.

Taxation on low duration funds

Low duration funds are taxed as debt funds for income tax purposes. The taxation depends on the holding period of the investment. The holding period is the duration for which the investor stays invested in the fund.

  • If the holding period is less than 36 months, the gains are classified as short term capital gains (STCG) and are taxed at the investor’s slab rate.
  • If the holding period is more than 36 months, the gains are classified as long term capital gains (LTCG) and are taxed at 20% with indexation benefit. Indexation is a process of adjusting the cost of acquisition of the investment with respect to inflation. This reduces the taxable amount of the gains and hence the tax liability.

Factors to consider while investing in low duration funds

While investing in low duration funds, there are certain factors that the investor should consider. These are:

  • Risk: Low duration funds are relatively low risk investments as they have a lower exposure to interest rate fluctuations and credit defaults. However, they are not risk-free. They still carry some degree of market risk, liquidity risk, and credit risk. Market risk is the risk of losing money due to changes in the market conditions. Liquidity risk is the risk of not being able to sell the securities at the desired price and time. Credit risk is the risk of the issuer defaulting on the payment of interest or principal.
  • Return: Low duration funds offer higher returns than bank deposits and other short-term instruments. However, they do not guarantee any fixed returns. The returns depend on the performance of the underlying securities, the fund manager’s strategy, and the market conditions.
  • Cost: Low duration funds charge a fee for managing the portfolio and providing various services to the investor. This fee is called the expense ratio and is deducted from the net asset value (NAV) of the fund. The expense ratio reduces the returns of the fund and hence it is better to choose a fund that has a low expense ratio.
  • Performance: Low duration funds should be evaluated based on their ongoing and past performance. This should be compared with the benchmark and the category average to assess the fund’s consistency and efficiency. You should also look at the portfolio composition, the credit quality, the yield, the duration, and the maturity profile of the fund to gauge whether it is right for you.

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Frequently Asked Questions

What is the difference between low-duration and ultra-low-duration mutual funds?

The distinction lies in the lending duration of these funds. Ultra-low-duration mutual funds extend loans for a maximum period of 6 months, while low-duration funds have the flexibility to lend for a horizon of up to 1 year.

What is the risk profile of the low-duration fund?

Given their marginally prolonged lending duration, these funds carry a higher level of risk compared to liquid and ultra-short-term funds.

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

Low-duration funds typically do not have a lock-in period, providing investors with flexibility in terms of entry and exit. This feature allows investors to manage their liquidity requirements efficiently.

What are the underlying assets of Low duration funds?

These funds allocate their investments across a diverse range of assets, including money market securities, government securities, hybrid instruments, corporate bonds, and other financial instruments.

Do short-term funds provide better returns than an FD?

Low-duration funds have the potential to provide better returns than fixed deposits, especially in a scenario of rising interest rates. However, investors should be mindful of the associated risks and the need for liquidity.

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