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Medium Duration Funds – Meaning, Features, Advantages and Limitations

medium duration funds
medium duration funds

Introduction

Medium duration funds are open ended debt mutual funds that are mandated to invest in securities with maturity around 3-4 years. These funds are subject to interest rate risk. The fund manager of these funds is free to invest across securities with different credit qualities.  Hence, they have significant default risk as well.

What are medium duration funds?

Medium duration funds are open-ended debt mutual funds that invest in securities such that the portfolio’s Macaulay duration is around 3-4 years. In other words, it means that medium duration funds have securities with maturities of 3-4 years.

The returns from these funds are more or less predictable. However, the returns aren’t guaranteed. They are subject to credit risk, interest rate risk and liquidity risk.

These funds have a longer duration than short term funds and hence are subject to interest rate risk. During the rising interest rate cycle, bond prices fall. Since these have a longer maturity than short duration funds, they are the most affected. Also, fund managers might invest in low rated securities with a hope that their credit rating might improve in the long run. Hence these funds are exposed to default risk as well.

Medium duration debt funds best suit investors with low to medium risk tolerance and an investment horizon of 3-4 years. Investors who want to invest in medium to long term fixed deposits can also look at investing in these. However, one has to consider the risks involved in investing in them.

Medium duration funds are taxed similar to debt funds. The short term capital gains (below three years) are taxable at the individual’s income tax slab rate. The long term capital gains are taxable at 20% with indexation benefit. Investors falling under the highest income tax can benefit from these by staying invested in these for a minimum of 3 years.

Features of medium duration fund

Returns

The returns from medium duration debt funds are foreseeable. One can expect a certain return from these investments as they invest in interest bearing securities. However, the returns are not guaranteed. The returns are subject to credit risk if the portfolio manager has invested in low credit quality securities.

Risk

Though debt mutual funds are considered as low risk investments when compared to equity funds, they aren’t completely risk free. Medium duration funds have high maturities, and their underlying securities can default payments. Hence, they are exposed to high interest rate risk, credit risk and liquidity risk.

Volatility

Medium duration funds are highly volatile in changing interest rate scenarios. While a falling interest rate regime boosts returns of these funds, rising interest rates have an opposite effect. The returns of these funds fall when interest rates rise. Longer the duration of securities in a fund, higher will be the fund’s volatility.

Investment horizon

The ideal investment horizon for medium duration funds is 3-4 years. This is because they have securities such that the Macaulay duration of the portfolio is around 3-4 years.

Portfolio

A portfolio manager of a medium term fund can invest in debt securities such that the portfolio’s maturity is around 3-4 years. The portfolio manager is free to invest across short duration (including money market instruments) and long term debt securities with high to low credit quality.

Taxation

Medium duration funds are taxed like debt funds. Short term capital gains are taxable at the investor’s income tax slab. Long term capital gains are taxable at 20% with indexation benefit. Investors who fall under the highest tax bracket can benefit from investing in such funds.

Things to remember before investing

Medium duration funds invest across money market and debt instruments. The Macaulay duration of these funds varies between three to four years.

Financial Objective

While investing, it is advisable to invest towards an investment objective or a financial objective. The investment duration, investment objective and investor’s risk tolerance levels play a major role in fund selection. Therefore, it is vital to invest in funds that perfectly align with the investor’s financial objective.

Investment Duration

The investment duration is an important factor that one has to keep in mind while investing. Every investment has a different suitable horizon. For example, investments in stocks or equities require long term investment duration. At the same time, debt category instruments wouldn’t require a very long investment horizon. Medium term funds have a Macaulay duration between three to four years. Therefore, investors with a minimum investment horizon of three to four years can consider medium duration funds. However, it is important to note the risks associated with these funds.

Risk

Medium duration funds invest in debt instruments with maturities between three to four years. Though these funds are less volatile when compared to pure equity investments. Medium duration funds also have certain risks associated with them. These funds are subject to interest rate risk, credit risk and liquidity risk. Due to the long maturity of the securities, these funds are affected by the changing interest rate cycle. Also, the fund manager might invest in low rated securities with an expectation that the ratings would get upgraded. Therefore, exposing the investment to default risk.

Credit Ratings

Investors must look at the credit ratings of the securities that the medium term bond fund invests in. This helps in understanding the level of default risk. If the medium term fund invests in too many low rated securities, then the fund has high credit risk. Therefore, it is important to invest in a fund that has a minimum or less exposure to securities with low ratings.

Cost

Returns from debt mutual funds are lower in comparison to equity mutual funds. Therefore, it is important to invest in funds with lower costs in order to earn significant returns. Each fund house charges certain fees for their fund management expertise. The cost is known as the expense ratio. It is good to invest in funds with a lower expense ratio. Also, funds have an exit load. Exit load is the penalty charged by the fund house to prevent premature withdrawals. Hence, while investing, it is essential to look at all the costs and pick funds with low expense ratio and exit load.

Tax on medium duration funds

Medium term debt funds are a type of debt mutual funds. Hence the taxation of these funds is similar to that of debt mutual funds. The gains from medium term debt funds are taxable on the basis of the investment holding period. For redemptions within three years of investment, the gains attract Short Term Capital Gains Tax (STCG). The gains are taxable at an individual’s income tax slab rate.

On the other hand, for redemptions after three years since the date of investment, the gains attract Long Term Capital Gains Tax (LTCG). The gains are taxable at 20% with indexation benefit or at 10% without any indexation benefit.

Moreover, an investor in the highest tax bracket can benefit from these investments by investing in them for a minimum of three years.

Who should invest?

A medium term plan is suitable for investors with low to medium understanding of risk. Also, investors with a medium duration horizon of 3-4 years can consider these funds as an option. The returns from these funds are not affected by equity market movements and are somewhat predictable. However, the returns are not guaranteed.

Moreover, these funds come with a risk attached to them. The medium term bond fund has high interest rate risk and default risk. Since these funds have a duration of 3-4 years, they are subject to interest rate risk. Also, the portfolio manager of the fund is free to invest in securities with different credit ratings. Hence, there can be a default risk in these funds.

Advantages and limitations

Advantages

Tax advantage

Medium term bond funds are comparatively more tax efficient than fixed deposits. However, the tenure of investment has to be three years or more. Also, investments in medium duration funds qualify for indexation benefit when the investment horizon is more than three years.

Disadvantages

No guaranteed income

Unlike fixed deposits, medium durations funds do not guarantee returns. Though the returns are predictable to some extent, a medium term plan does not guarantee returns. Investments in medium duration funds are subject to risks such as default risk, liquidity risk and interest rate risk.

Risks

Investments in medium duration funds are not completely risk free. These investments are subject to certain risks such as interest rate risk, credit risk and liquidity risk. The change in interest rates has a negative impact on the prices of bonds. Since the duration of these funds varies between three to four years, the funds are exposed to interest rate risk.

The fund manager invests in certain securities with low ratings with an expectation that the rating would upgrade. This exposes the fund to default risk.

Additionally, during redemption pressure, sometimes it becomes difficult for the fund manager to exit their positions. This exposes the investments to liquidity risk.

What are the fund categories under equity funds?

Equity mutual funds asset allocation is such that they invest at least 65% of their corpus in stocks. Since equity funds invest in stocks, they have a significant amount of risk associated with them. As a result, the returns are higher in comparison to other mutual funds. One can invest in equity mutual funds through SIP and lump sum route. SIP investment is the most popular mode of investing. One can calculate their potential SIP return through a SIP calculator. Scripbox’s SIP calculator helps in estimating the SIP return online.

Following are the categories under equity funds:

Read our guide to know more about the basics of mutual funds, it’s types and how they work.

Conclusion

Medium term bond funds invest in securities with maturities of 3-4 years. This is a small category (less than 2% of the total debt fund assets). They are open ended debt mutual funds suitable for an investment horizon of 3-4 years. This exposes them to interest rate risk. Also, the credit quality of funds in this category was relatively poor.

Scripbox doesn’t recommend funds in this category because of the higher default risk and higher interest rate risk.

Frequently Asked Questions

What are the other fund categories of debt funds apart from medium duration funds?

Debt mutual funds invest a major part of their corpus in fixed income or debt instruments. For example, debt mutual funds invest in fixed income instruments such as government securities, debentures, money market instruments, and corporate bonds. In comparison to equity mutual funds, debt funds are low-risk investments. The fund manager strategies the asset allocation is such a way that the portfolio comprises high-quality instruments. Apart from medium duration mutual funds, the following are the other categories of debt funds.
1. Liquid Funds
2. Ultra Short Duration Fund
3. Low Duration Fund
4. Money Market Funds
5. Short Duration Mutual Funds
6. Corporate Bond Funds
7. Medium to Long Duration Mutual Funds
8. Long Duration Funds
9. Dynamic Bond Funds
10. Credit risk funds
11. Overnight Funds
12. Banking and PSU Funds
13. Gilt Funds
14. Gilt Fund with 10 year constant duration
15. Floater Funds 

Published on September 15, 2020