Best Low Duration Mutual Funds

Low duration funds are open-ended debt schemes that invest your money in short-term debt securities. The Macaulay duration of these investments is between 6-12 months. A Low term fund gives a better short-term return as compared to liquid funds. Low tenure funds leverage investment rate movements to offer liquidity and return at moderate risk. Fund Managers put your money in low-duration fixed income instruments to generate significant returns.

A large number of investors prefer to keep their money in a savings account. They avoid investing in Mutual funds because they involve market risk. However, Low-duration funds offer such investors liquidity while reducing the risk. It makes them suitable for individuals with lesser risk appetites as they are conservative about their resources. Investors can gain from interest rate changes and get high returns upon investing in Low term funds.

What are Low Duration Funds?

Low-duration Funds invest your money in market instruments and debt securities. They ensure the Macaulay Duration of the fund is between six and twelve months. These funds are suitable for investors who are willing to take low-risk. You can invest in these funds if you have a one-year investment horizon. The maturity of these funds is high in comparison to liquid funds and overnight funds. But it is lower when compared to short, medium, and long duration funds. These funds are ideal for investors who wish to park their money for 6-12 months. You can earn better returns with Low Duration Funds than a regular savings account. The average returns on your investment would range between 6.5 and 8.5%. 

Top 5 Mutual Funds for Low Duration Investment 2024

Fund Name	3 Year Returns	5 Year Returns
HDFC Low Duration	6%	6%
DSP Low Duration Fund	6%	5.7%
Kotak Low Duration Fund Standard Plan	5.8%	5.8%
SBI Magnum Low Duration Fund	5.8%	5.8%
Nippon India Low Duration Fund	5.9%	5.9%

How do Low Duration Mutual Funds Work?

Low-duration funds work on the concept of duration. Any investor must understand the duration concept before investing in these funds.

The duration of a debt fund affects its investment decisions. It also defines the type and amount of returns earned by the fund.

Duration

The duration of a debt fund measures the fluctuations in a fund’s value in response to the changes in market interest rates. We also refer to duration as interest rate risk. Therefore, the fund value becomes more volatile with higher duration and the associated interest rate risk is greater.

Calculating duration requires a complex formula and data on the fund’s investments. Investors can skip the tedious process and follow a simple thumb rule to estimate fund time horizon. It can be derived through the maturity of bonds held by the mutual fund. Funds holding long-maturity bonds will have a higher tenure and those holding shorter maturity bonds will have a low term. If a fund increases holdings of long-term bonds its duration and interest rate risk increase.

Definition of Low Duration

SEBI has laid down rules to define fund duration. As per the guidelines, Low duration funds have to maintain a duration between 6‐12 months. Low-duration funds generally invest in short-term debt securities. Thus, they have relatively low interest rate risk. The restrictions are on the duration of funds not on the type or credit quality of debt assets. Hence low duration funds invest in a wide range of securities. These include:

• Money market securities
• Government securities
• Corporate bonds
• Securitized debt
• Hybrid instruments like REITs, Permitted derivatives, or even other mutual fund units

Sources of Earnings

Low duration funds earn from debt securities. Their earnings are from interest as well as capital gains. Interest earnings come from holding a part of their assets in bonds with credit ratings of AA or lower. These bonds pay relatively higher interest rates in comparison to lower-rated bonds that yield more. But the risk of default is more with lower-rated bonds.

Low-term funds also take some credit risk to deliver higher returns to their investors. They have the potential to generate capital gains by increasing exposure in longer maturity bonds. Fund managers respond to falling interest rates by exposing more to long-maturity bonds. It helps in pushing up the value of the fund. Thus, these short term funds generate returns for investors by using strategies based on credit risk as well as interest rate risk.

Advantages of Investing in Low-Duration Funds

• Moderate Risk: Low-duration funds expose your money to a moderate level of interest rate risk. These funds do not usually hold securities with a maturity higher than 1‐1.5 years. It becomes a win-win situation as you get good returns with interest rate fluctuations in the market. To understand this simply, consider interest rates are falling but your investment is at a lesser risk. As the loss of interest income on fresh bonds will be much lesser than the capital gains on existing bond values. 
  Now if interest rates are increasing again you are exposed to lesser risk. As the funds cut back on the tenure and capital losses minimize. You are also simultaneously earning higher interest rates on the new bonds. Thus, we see the value of low term funds is less volatile in contrast to longer-duration funds. Earlier there were no well-defined credit exposure norms for ahort term funds. However, now most low-duration schemes hold reasonably good quality debt. This fund category is suitable for investors with a moderate risk appetite.
• High Returns: Low-duration mutual funds take on greater credit and time horizon exposure. They generally outperform liquid funds in terms of returns. These fund schemes also have the potential to give better returns than ultra-short duration funds. The funds make higher capital gains by holding longer-duration maturity bonds.

Limitations of Investing in Low Duration Mutual Funds

Low duration mutual funds are subject to credit risk. As these funds invest in lower-quality debt instruments (lower-rated paper), they expose investments to a higher chance of default. Low term funds have a moderate level of risk. This means the chance of loss from the change in interest rate is moderate. However, you must also understand the interest rate risk that exists in all debt funds. 

Who should Invest in Low Duration Mutual Funds?

You can invest in low duration mutual funds if you are among the following categories of investors:

• You have an investment horizon of more than 3-months: Low-duration fund schemes are ideal for you if your investment horizon is of 3 months or higher. If you have a very short investment horizon then you must opt for low-risk overnight or liquid funds. However, if you have a holding period longer than 3 months then low term funds offer better returns. You enjoy higher returns in exchange for slightly greater risk. You can select these funds for temporarily parking your surplus earnings. These may be from the sale of a property or an annual bonus. The mutual fund has a low tenure making it ideal for accumulating funds for fulfilling a short-term financial goal.
• You want regular income: Low term funds provide investors a regular income. You earn returns from your mutual funds through a combination of interest earnings and capital gains. If you have a moderate risk appetite you can allocate a part of your portfolio to low term mutual funds. Use an SWP (Systematic Withdrawal Plan) to create a steady income flow.
• You want an alternative to bank deposits: You may find these funds more attractive than bank deposits if you have a moderate risk appetite. These funds offer better liquidity and you also earn higher market‐linked returns.

Things To Consider for Investing in Low Duration Funds

You must consider these important factors before processing investment in low-duration funds:

• Financial Goal: Analyze your financial goals before making an investment decision. Choose funds that help you meet the end goals. An important point to note is that you must not park your emergency funds in Low duration mutual fund schemes.
• Returns: Low duration mutual funds have the potential to perform efficiently over a period of 6 months to 1 year. You must analyze the performance of your investments over this duration.
• Investment Horizon: You must invest in short-term funds if you have a minimum investment horizon of 3 months. However, you can earn better returns over a longer duration
• Risk Tolerance: Low duration mutual funds involve moderate risks and are not entirely risk-free. You must keep track of the degree of risk you are willing to take. Check the time horizon of your fund to evaluate an increase in its interest rate risk.
• Fund Portfolio & Management: Conduct thorough research about the Fund House and Fund Manager before investing. It assures you that your funds are in safe hands
• Expense Ratio and other costs: The fund house charges an annual amount for the management of your portfolio. This is called the Expense Ratio. This amount is calculated as per norms of the Securities and Exchange Board of India (SEBI). A fund house can charge a maximum 1.05% expense ratio for managing Low term fund schemes. It is recommended to track the expense ratio involved with your investment to avoid paying excess charges.
• Tax Treatment for Low Duration funds: Short-term Capital Gains (STCG) on Low term funds are taxable on the basis of the income slab of the investor. No tax is applicable on the dividend earned by the investor. But you will be liable for a 20% tax after the benefit of indexation in the case of Long-Term Capital Gains (LTCG). The rate of tax on capital gains depends on the duration for which the units were held.
  However, from April 1st 2023, the LTCG benefit for debt mutual funds has been removed. Capital gains from the said date will be taxed as per the investor’s applicable income tax slab rate.

Summary

As we have seen, Low duration mutual funds are debt funds. It gives your money exposure in a range of money markets and debt securities if your portfolio duration is between 6 to 12 months. Low-term funds are the lowest risk ones among all other duration-based schemes. They still have a higher interest rate and credit risk when compared to liquid and overnight funds. Low-duration funds earn a good return through a combination of interest and capital gains on the debt holdings. You can select short term funds if you have a financial goal to be met within an investment horizon higher than 3 months. Investors can leverage the potential of these funds to earn a regular income with moderate risk. You can also use it as a medium to route funds in the equities market or other long-term funds.

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