Low Duration Funds

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.

• What is Duration:

  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.

• Defining Low Duration:

  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.

• Where do low duration funds invest:

  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.

• Sources of Earnings:

  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.

• Moderate Risk: Low duration funds carry a moderate level of interest rate risk, as they do not usually hold securities with maturities higher than 1‐1.5 years.
  This puts them in a win-win position: when interest rates fall, the loss of interest income on fresh bonds is much lesser than the capital gains on existing bond values. When interest rates increase, the funds cut back on duration to minimize capital losses, while simultaneously earning higher interest rates on new bonds. Thus, the value of low duration funds is less volatile as compared to longer duration funds. Post the 2018 NBFC crisis, credit risk has been a matter of concern for investors, primarily because there are no credit exposure norms for low duration funds. However, most of these funds hold reasonably good quality debt, so the fund category remains suitable for investors with moderate risk appetite.
• Higher Returns: Low duration funds usually outperform liquid funds because they are allowed to take on greater credit and duration exposure. Low duration funds also have the potential to beat ultra-short duration funds, as they can make higher capital gains by holding longer maturity bonds.

• Investors with more than 3-month investment horizon:

  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.

• Investors who want regular income:

  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 who want an alternative to bank deposits:

  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.

• Medium to Route investments in Equity Funds:

  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.

• Short term Capital Gains Tax:

  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.

• Long term Capital Gains Tax:

  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.

• Return: Since a low duration fund invests mainly in short term debt, it is appropriate to assess its performance on the basis of 6-month or 1‐year returns. A well-performing low duration fund will earn returns that beat its benchmark as well as the returns earned by comparable peer funds. More importantly, the best performing funds consistently earn good returns. Hence, instead of being impressed by the most recent return number, investors should examine returns generated in previous years to make sure that the fund has regularly performed well.
• Risk: Low duration funds carry both interest rate risk and credit risk. Investors should track the duration of the fund- which is published each month- to evaluate if the fund has increased its interest rate risk. The portfolio composition should also be tracked to judge the credit quality of the fund's bond holdings. If a low duration fund invests a significant part of its assets in lower-rated debt, it faces a higher risk of default, which may not necessarily match the investor's risk tolerance.
• Expense Ratio: The expense ratio is the annual amount charged by a fund for managing the portfolio. The net return to the investor is calculated after subtracting the expense ratio. Low duration funds typically have low expense ratios. However, it is important to keep track of this parameter as it impacts the final investor return. An increase in the expense ratio- either sudden or gradual- needs to be analyzed and understood.
• The table below shows the top 5 low duration funds ranked by 6-month and 1-year return. Note that there is a difference of 0.42% in terms of 1-year returns between the best and worst-performing funds. This shows that a low duration fund has the potential to outperform its peers using appropriate credit or duration strategies. The six-month returns are absolute returns- which means that they have to be annualized to make them comparable with other savings options. For example, the 6-month return earned by the top-ranked low duration fund is 4.99%, which is approximately equal to an annualized return of 4.99% x 2 = 9.98%. The expense ratios are not widely different for the funds considered in this table, and all are well below 1%. The next level of analysis should be to measure the consistency of returns by tracking 6-month and 1-year returns in previous years.

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.

• Low duration funds are debt funds that invest in a range of money market and debt securities such that the portfolio duration is between 6 to 12 months.
• Low duration funds have a higher interest rate and credit risk as compared to liquid and overnight funds, but they are among the lowest risk funds within the family of duration funds.
• Low duration funds earn through a combination of interest and capital gains on their debt holdings.
• By holding a part of their assets in lower-rated bonds, low duration funds can boost their interest incomes. They also actively manage duration to generate capital gains.
• Low duration funds offer reasonably high returns for a moderate amount of risk. Investors with moderate risk appetite can opt for these funds as an alternative to savings and fixed deposits.
• Low duration funds are most suitable for investors with an investment horizon higher than 3 months, investors who can accept some risk in return for the potential to earn a regular income, or for use as a medium to route funds into other long-term funds.