Debt Mutual Funds

Debt mutual funds can be classified according to the duration of the securities they hold, the types of issuers involved, or their fund management strategies. Based on the duration of the fund, these classifications include categories such as ultra-short-duration funds, short-duration funds, medium-duration funds, and long-duration funds, among others.

Low-duration funds are one such specific type of debt fund that concentrates on short-term debt securities, with a portfolio duration ranging between 6 to 12 months.

In this article, we will explore what low-duration funds are, covering their advantages and risks and look at the process of investing in them. We'll also understand the key difference between a short-duration and low-duration fund.

What is Low-Duration Fund?

According to SEBI guidelines, low-duration mutual funds are categorised as debt mutual fund schemes that predominantly invest in a basket of debt and money market instruments, including sovereign bonds, AAA or AA-rated securities, and cash and cash equivalents. These open-ended funds have a portfolio duration of 6 to 12 months.

The duration here refers to the sensitivity of the fund's portfolio to changes in interest rates. By keeping the duration low, these funds aim to reduce exposure to fluctuations in interest rates. Also, focusing on securities with shorter maturity periods, low-duration funds tend to provide more stable returns and carry less credit risk compared to longer-term debt funds.

Best Low Duration Mutual Funds

List of the top-performing low duration mutual funds sorted by returns with their AUM and Expense Ratio.

Features of Low-Duration Fund

By maintaining a short-term maturity, low-duration funds limit their exposure to fluctuations in interest rates, thus reducing the overall interest rate risk. Let's look at some more interesting features of these funds:

Short Maturity: The maturity of the securities held in low-duration funds ranges between 6 to 12 months, keeping interest rate risk low. This is because short-term debt instruments tend to adjust more quickly to changes in interest rates, reducing the impact on their market value compared to longer-term debt securities. As a result, investors in low-duration funds experience less volatility and are better shielded from the adverse effects of rising interest rates.

Moderately Low Credit Risk: A significant portion of their investments is typically allocated to AAA-rated or sovereign-rated (government-backed) securities. While there is always a degree of credit risk with any debt investment, focusing on highly-rated securities ensures that the risk of default is minimised.

Advantages of Investing in Low-Duration Funds

Investing in low-duration funds offers several advantages, particularly for risk-averse investors who prioritise capital preservation over high returns.

Lower Risk Profile: One of the most significant advantages is the reduced exposure to interest rate risk due to the short duration of the fund. Investors face less volatility compared to long-term debt funds or equity funds.

Stable Returns: Since low-duration funds invest in short-term debt instruments, the returns are relatively stable and predictable. This makes them an attractive option for investors looking for safer, short-term investments.

Diversification of Assets: Low-duration funds often invest in a mix of money market securities, short-term corporate bonds, and government securities, which spreads out the risk and helps in mitigating potential losses.

Ideal for Short-Term Financial Goals: Investors who want to park their money for a short duration, like 6-12 months, may benefit from these funds.

Disadvantages of Investing in Low-Duration Funds

While low-duration funds have numerous benefits, there are also some downsides to consider:

Interest Rate Sensitivity: While low duration funds are less sensitive to interest rate changes, they're not entirely immune. If interest rates rise, the value of the fund's underlying securities may decline, impacting its returns.

Credit Risk: Low-duration funds may still be exposed to some credit risk since their investments include AA-rated securities.

Reinvestment Risk: When low duration bonds mature, the fund manager may have to reinvest the proceeds in other securities. If interest rates have declined since the initial investment, the fund may have to reinvest at lower rates, potentially impacting future returns.

Who Should Invest in Low-Duration Funds?

Low-duration funds could be an excellent choice for:

Conservative Investors: Those who prioritise safety over higher returns and are looking for a moderately low-risk investment.

Investors with Short-Term Goals: Individuals aiming to invest for a short period - between six months to one year - can benefit from the stability and lower interest rate risk offered by low-duration mutual funds.

Risk-Averse Individuals: If you want to avoid the market volatility of equity funds or the higher risk of long-term debt funds, low-duration funds provide a more conservative approach.

Factors to Consider Before Investing in Low-Duration Funds

Before deciding to invest in low-duration funds, consider the following:

Investment Horizon: A low-duration fund is best suited for investors with a short-term investment horizon. Let's say you want to park your funds for a shorter period of time and you don't know if you might need them in the next 3 or 6 months. If that resonates with you, low-duration mutual funds can be a good option. So, take your investment horizon into consideration before making any decisions.

Fund Managers' Expertise: The skill and experience of the fund manager can significantly impact the performance of a low-duration fund. Look for a fund manager with a strong track record in managing debt securities.

Expense Ratio: The expense ratio is the annual fee charged by the AMC. A lower expense ratio is generally better, as a higher fee reduces the overall returns on your investment.

Portfolio Diversification: Investors should carefully review the types of securities in which the fund invests. It's important to assess how the fund allocates assets across various securities, such as sovereign bonds and other instruments, to gauge the stability and risk level of the portfolio.

Taxation of Low-Duration Mutual Funds

The taxation of low-duration mutual funds follows the same structure as other debt funds, with tax treatment varying based on the investment date and the holding period. Here's how it works:

Invested Before April 1, 2023:

Short-Term Capital Gains (STCG): If units are held for less than 24 months, any gains realised from selling these units are classified as short-term capital gains. These gains are taxed according to the investor's applicable income tax slab rate.

Long-Term Capital Gains (LTCG): For units held for more than 24 months, the gains are classified as long-term capital gains and are taxed at 12.5%.

Invested After April 1, 2023:

For all investments made on or after April 1, 2023, both STCG and LTCG are taxed at the investor's applicable income tax slab rate, irrespective of the holding period. This means that the distinction between short-term and long-term gains no longer applies, and all gains are subject to the investor's marginal tax rate.

How to Invest in Low-Duration Funds

You can invest directly in low-duration mutual funds through the asset management company's website, or you can use INDmoney to invest online in the best low-duration mutual fund in a few easy steps:

• Open the INDmoney app and log in with your credentials.
• Go to the "Mutual Funds" section within the app.
• Use the filter options to select "Low-Duration Mutual Funds" to see the available options.
• Choose between a lump sum investment or a Systematic Investment Plan (SIP) for ongoing investments.
• Enter the amount you wish to invest and confirm the transaction.