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Low duration funds are debt funds that invest in short term debt securities, such that the duration of the fund portfolio is between 6 to 12 months. As compared to overnight or liquid funds, low duration funds hold assets of longer maturity and/or lower credit quality; therefore, they have a relatively higher interest rate risk and credit risk.
To understand how low duration funds work, it is necessary first to understand the concept of duration. That is because the duration of a fund affects its investment decisions as well as the type and amount of returns earned by it.
The duration of a debt fund measures how much the fund's value fluctuates in response to changes in market interest rates. Duration is also known as interest rate risk. Therefore, the higher the duration, the more volatile the fund value, and the greater its interest rate risk. Calculating duration is quite tedious and requires a complex formula and detailed data on the fund's investments. For most investors, a good thumb rule is to estimate duration based on the maturity of bonds held by the fund. Funds holding long-maturity bonds have higher durations as compared to funds that hold shorter maturity bonds. If a fund increases its holdings of long-term bonds, the duration of the fund increases, as does its interest rate risk.
According to SEBI rules, low duration funds have to maintain fund duration between 6‐12 months. This means that low duration funds are likely to invest in short term debt securities only. Thus, low duration funds have relatively low-interest rate risk.
There are no restrictions on the type or credit quality of debt assets to be held by low duration funds. Hence these funds invest in a wide range of securities, including money market securities, government securities, corporate bonds, securitized debt, hybrid instruments like REITs, permitted derivatives, or other mutual fund units.
Low duration funds earn through interest as well as capital gains from their debt securities. These funds boost interest earnings by holding a part of their assets in bonds with credit ratings of AA or lower, which pay relatively higher interest rates. Remember, lower-rated bonds yield more but also increase the risk of default.
Most low duration funds will take on some credit risk to deliver higher returns. Low duration funds also have the potential to generate capital gains. When interest rates are falling, fund managers will increase exposure to longer maturity bonds in order to push up the value of the fund. The loss of interest income from investing fresh inflows at lower interest rates will be more than made up by the gain in the capital value of existing bonds. Thus, low duration funds use strategies based on credit risk as well as interest rate risk to generate returns.
Low duration funds are ideal for those with an investment horizon of 3 months or higher. Investors with very short investment horizons are better off investing in low risk overnight or liquid funds. However, for holding periods longer than 3 months, low duration funds offer higher returns in exchange for a small increase in risk. Investors can use them for temporary parking of surpluses from the sale of a property, annual bonus, etc., or for accumulating funds towards a short-term financial goal.
Low duration funds provide regular income through a combination of interest earnings and capital gains. Investors with moderate risk appetite can allocate a part of their portfolio to these funds and use an SWP to create a stream of income flows.
Investors with a moderate risk appetite may find low duration funds more attractive than bank deposits as they offer better liquidity as well as have the potential to earn higher market‐linked returns.
Low duration funds can be used to hold funds while using an STP to route investments systematically into an equity fund or hybrid fund. While it is more common to use liquid funds as the holding vehicle, investors with a slightly higher risk tolerance can benefit from the higher return potential of low duration funds.
There are two main concerns with investing in low duration funds.
First, these funds may have significant exposure to low‐quality debt. A large default can cause fund value to drop sharply, and investors may have to choose between holding their discounted units or selling out at a loss. To avoid this, investors in low duration funds should track the rating profile of the debt portfolio, issuer‐wise exposures, as well as the credentials of the debt issuer.
Second, low duration funds actively manage duration to generate returns; hence, fund values are subject to some volatility. Investors must recognize this interest rate risk and ensure that it matches their risk appetite and goals. For example, it is not a good idea to use low duration funds to park emergency or contingency funds; instead, they can be used to grow funds towards a financial goal in the short term.
Investors earn dividend income and capital gains from low duration funds. Dividend income is not taxable for investors. However, capital gain, which is the difference between the purchase price and selling price of the units, is taxable. The rate of tax on capital gains depends on how long the investor has held the units of the low duration fund.
If an investor holds the units of the fund for up to 3 years, capital gains are considered as short‐term capital gains and taxed at the income tax slab rate applicable to the investor.
If an investor sells the units of a low duration fund after holding it for more than 3 years, it is classified as a long-term capital gain. In this case, the investor is allowed the benefit of "indexation," which means that before calculating the capital gain, the purchase price can be increased to adjust for inflation (using an index provided by the Government). In other words, the taxable amount is reduced due to indexation. Long term capital gains are currently taxed at a lower rate of 20%.
A low duration fund should be evaluated in terms of return, risk, and expense ratio.
|Fund Name||3-year Return (%)*||5-year Return (%)*|
|Kotak Low Duration Fund Direct-Growth||6.14%||6.98%||Invest|
|Aditya Birla Sun Life Low Duration Fund Direct-Growth||6.17%||6.98%||Invest|
|HDFC Low Duration Fund Direct Plan-Growth||6.06%||6.68%||Invest|
|Axis Treasury Advantage Direct Fund-Growth||5.61%||6.67%||Invest|
|ICICI Prudential Savings Fund Direct Plan -Growth||5.88%||6.63%||Invest|
*Last updated as on 12th Sep 2022
In addition, the fund portfolio should be checked to evaluate the credit risk of the fund. The monthly fact sheet published on the website of the fund house shows details of the portfolio, including rating of the debt security as well as its share in total assets. The key red flags for a retail investor would be‐ excessive concentration of the portfolio in any one instrument or bond or large exposure to lower-rated bonds. A comparison with portfolio details of peer funds is also a good way to judge if the fund is taking on risks beyond the industry average. Remember, both risk and return features of a fund should be evaluated before choosing a low duration fund to invest in.
The difference is the tenure for which these funds lend. While ultra low duration mutual funds lend for a period of up to 6 months, low duration funds are allowed to lend for up to 1-year horizon
Since these funds lend for a slightly longer duration they are riskier than liquid and ultra short duration funds.
There is no rule for this. Each fund house decides on whether they will charge an exit load, and if they do, what percentage and for what period. So do check this before investing.
No. There is no lock-in period in low duration funds
Low Duration Mutual Funds have some risk attached to them owing to their lending duration. Moreover, since there is no regulation on what kind of companies they are lend to, sometimes funds can lend to risky borrowers to bump up the returns.