What is Low duration fund?
Investing in mutual funds can be a great way to grow your money, but with so many options to choose from, it can be difficult to know where to start. One type of mutual fund that is worth considering is a low duration fund. But what exactly is a low-duration fund and how does it differ from other types of mutual funds? In this article, we'll take a detailed look at what these funds are, their features, and why they may be a good choice for your investment portfolio.
What is a Low Duration Fund?
A low duration fund is a type of debt mutual fund that invests in fixed income securities with a short-term maturity. The duration of a bond or fixed income security refers to the amount of time it takes for the bond's price to be repaid by its cash flows. This type of fund typically holds securities with maturities of 1-3 years.
The best low duration fund aims to provide relatively stable returns with less interest rate risk compared to longer-term bond funds. Because of their shorter maturity, these funds are less sensitive to interest rate changes and provide more stability in comparison to other types of debt funds like long-term or gilt funds.
Let’s understand few more conceptual terms.
Duration:
Duration is a measure of the sensitivity of a bond or a bond fund's price to changes in interest rates. The higher the duration, the more sensitive a bond is to changes in interest rates. In the context of a low duration fund, duration typically refers to a duration of less than 3 years.
Risks:
When it comes to investing in low duration debt funds, there are two types of risks that investors should be aware of - credit risk and interest rate risk. Credit risk refers to the default risk of the bonds held in the fund and Interest rate risk refers to the risk of loss due to changes in interest rates. Low duration funds generally have lower credit and interest rate risk than other debt funds.
Returns:
Investors can expect to receive lower returns on low duration funds as compared to other debt funds, but they are also less volatile. Returns on these funds can be influenced by the credit quality of the bonds held in the fund. The interest income is taxed as per the investor's income tax slab. Short-term capital gains (on holding period < 3 years) are added to the income and taxed as per the income tax slab. Long-term capital gains (on holding period > 3 years) are taxed at 20% with indexation benefit.
Low Duration Funds vs. Other Debt Funds
Low duration funds are different from other types of debt funds in a few key ways.
- Maturity: As mentioned earlier, low duration funds hold securities with shorter maturities than other types of debt funds. This means they are less sensitive to interest rate changes and provide more stability.
- Risk: A low duration fund is considered to be less risky among other types of debt funds, as it is less susceptible to interest rate fluctuations.
- Returns: Low duration debt funds have lower returns when compared with other debt funds, but they also have a lower level of risk.
- Credit risk: These funds have comparatively less credit risk as they invest mostly in high-quality bonds, in most cases, AAA-rated.
Factors To Consider
When it comes to finding the best low duration fund for your investment portfolio, it's important to do your research and consult with a financial advisor. That being said, there are a few key factors to consider when evaluating different funds.
Performance: It's important to look at the fund's historical performance, including its returns and volatility. A fund with a consistent performance track record is generally considered to be a better option.
Fund Manager: The experience and track record of the fund manager can also be a key factor in the fund's performance. It's important to look for a fund manager who has experience managing similar funds and a solid track record.
Fund Size: A larger fund may be more stable and have more resources available, but a smaller fund may be more nimble and able to take advantage of new opportunities.
Fund Expense Ratio: Don’t forget to take into account the expense ratio of the fund, which is the percentage of assets that go towards administrative and management costs. Lower expense ratio generally indicates more value for the investor.
Why Invest in Low Duration Funds?
Low duration debt funds may be a good choice for your investment portfolio for a few reasons.
- Stability: As mentioned earlier, low duration funds are less sensitive to interest rate changes. This means they can provide relatively stable returns over time.
- Credit Risk: They invest in high-quality bonds and thus have less credit risk.
- Liquidity: A low duration fund also has a high level of liquidity, which means it can be easily converted to cash. This can be helpful in case you need to withdraw your money quickly.
- Diversification: Low duration funds can be a great way to diversify your investment portfolio. Thanks to their lower level of risk and volatility.
Limitations of Low Duration Funds:
Low duration funds come with certain limitations that investors should be aware of. One of the main limitations is that they generally offer lower returns compared to other debt funds, which may not be suitable for investors with a higher risk tolerance or a longer investment horizon. These funds are also less flexible in their investment strategies and may not be able to take advantage of opportunities presented by changes in interest rates.
Another limitation is that these funds tend to have a higher concentration of holdings in shorter maturity bonds that are considered to be less creditworthy than longer maturity bonds. This increases the credit risk and may lead to higher defaults in case of a downgraded bond in the portfolio.
In conclusion
A low duration fund is a type of debt mutual fund that invest in fixed income securities with shorter maturity period. They generally have lower interest rate risk and have the potential to generate higher returns during falling interest rate scenarios. However, these funds come with certain limitations, such as offering lower returns, having less flexibility in investment strategies, and also having higher credit risk. Investors should carefully consider these factors before investing in low duration funds, and should ensure that they align with their investment objectives and risk tolerance.