Low Duration Funds
Low Duration Funds are debt mutual funds that invest in debt and money market instruments such that the Macaulay Duration of the portfolio is between 6 months and 12 months. This duration range aims to strike a balance between interest rate risk and returns, providing a relatively low-interest rate risk compared to longer duration funds, while targeting moderate returns.
Key Features of Low Duration Funds:
- They invest in a mix of debt and money market instruments such as government securities, corporate bonds, treasury bills, and commercial papers with maturities of 6 to 12 months.
- Moderate Interest Rate Risk: Due to their short duration, these funds have lower sensitivity to interest rate changes compared to long-term debt funds, making them less volatile during interest rate fluctuations.
- Moderate Credit Risk: While they may involve slightly higher credit risk than liquid funds, most hold reasonably good quality debt.
- Balanced Risk-Return Profile: They aim to provide moderate returns higher than liquid funds but lower than long-term debt funds, striking a balance between risk and return.
- Short Investment Horizon: Suitable for investors with a short-term investment horizon of about 6 months to 1 year.
- High Liquidity: These funds offer high liquidity allowing investors to redeem their investments quickly with minimal exit loads.
- Diversification: They typically maintain a diversified portfolio across various debt instruments.
- Potential for Regular Income: Provide regular income from coupon payments on underlying bonds.
- Performance: They generate returns through a combination of interest income and capital gains, benefiting from flexible portfolio management to adjust duration in response to interest rate movements
How Does Low Duration Funds Works:
- These funds invest in a mix of debt securities such as government bonds, corporate bonds, treasury bills, commercial papers, and other short-term instruments with maturities confined to about 6 to 12 months to maintain a low duration.
- The performance and value of Low Duration Funds are influenced by interest rate movements. Duration measures the fund’s sensitivity to interest rate changes: shorter duration means lower interest rate risk and less volatility. Low Duration Funds manage this risk by keeping portfolio maturity short.
- Fund managers actively manage the portfolio by adjusting duration and credit exposure based on market conditions. For example, when interest rates fall, managers may increase holdings of slightly longer maturity bonds to gain capital appreciation, and when rates rise, they cut duration to minimize losses and capture higher interest on new bonds.
- Low Duration Funds generate returns through two main avenues:
- Interest income from the coupon payments of the bonds and money market instruments they hold.
- Capital appreciation arising from changes in bond prices, especially when interest rates fluctuate.
- They may also take on moderate credit risk by holding bonds with slightly lower credit ratings (e.g., AA or lower) to earn higher yields, balancing risk and return.
- These funds aim to offer a moderate level of risk and return, higher than liquid funds but with lower volatility compared to long-term debt funds.
Pros and cons
Pros:
- Suitable for short to medium-term investment horizons, typically 6 to 12 months.
- Lower interest rate risk compared to long-duration debt funds due to shorter maturities.
- Offer moderate returns, generally higher than liquid funds and bank savings accounts.
- Provide higher liquidity, allowing quick buy/sell transactions at NAV.
- Diversified portfolio across high-quality government and corporate bonds reduces credit risk.
- Active fund management helps optimize yield and manage risks based on market conditions.
- Potential for some inflation hedge by generating regular income through coupons.
- Useful as a safer alternative to equity in volatile or uncertain interest rate environments.
- Can complement other asset classes for portfolio diversification and risk balance.
Cons:
- Returns may not keep pace with inflation over the long term, leading to erosion of real purchasing power.
- Credit risk still exists due to potential issuer default, though generally moderate.
- Limited risk diversification compared to equity or more diversified bond funds.
- Performance depends on the interest rate environment and may underperform in declining rate scenarios.
- Not suitable for long-term wealth accumulation goals; primarily for short- to medium-term needs.
- Market timing to maximize returns can be challenging and is not guaranteed.
- May provide lower returns compared to other higher-risk investments like long duration debt or equity funds.
