Low Duration Funds

Low duration funds are open-ended debt mutual fund schemes that invest in debt and money market instruments with Macaulay duration of the portfolio between 6 to 12 months. Macaulay duration is like an average wait time for all your money back from a bond, considering both interest payments and final repayment, and helps you understand how sensitive the bond's price might be to interest rate changes.

These funds aim to provide investors with a slightly higher return than traditional savings accounts or fixed deposits while maintaining a low level of interest rate risk. As of February 29, 2024, this fund category has assets under management (AUM) of Rs 95,695.70 crore with 20 schemes with the oldest being 11 years old, and the category ranked 5th in the list of open-ended debt funds according to the Association of Mutual Funds in India (AMFI).

Source: AMFI website as of February 29, 2024

While you should identify your risk profile and plan your financial goals before investing in low duration funds, here are some situations where they may fit in:

Alternative to Savings Account and 1 year Bank Fixed Deposits

As of February 19, 2024, low duration funds offer annual returns between 7.26-8%, outperforming both bank savings accounts (2.7-3.0%) and 1-year fixed deposits (6.6-7.1%). While subject to market fluctuations, low duration funds provide a compelling opportunity for potentially higher returns.

Source: Valueresearch, SBI, HDFC Bank, ICICI Bank, BOB websites as of February 19, 2024

Note: While low duration funds are good alternatives to bank savings accounts and fixed deposits, they are not insured like them. Up to Rs. 5 lakh per bank account are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC).

Medium-Term Financial Goals

Investors with medium-term financial goals, such as saving for a down payment for a home or funding education expenses may find these mutual funds suitable. These funds provide a balance between potential returns and moderate interest rate risk.

Dividend Taxation

These funds pay out dividends when you invest in their IDCW (Income Distribution Cum Withdrawal) option. Dividends are taxed at your marginal income tax rate, and TDS (Tax Deducted at Source) at 10% applies to dividends received more than Rs 5,000 per AMC per financial year.

Potential for Better Returns

Compared to ultra short-term funds, low duration funds may offer slightly higher potential returns. This makes them attractive to investors looking for a balance between safety and return.

Moderate Interest Rate Risk

These funds aim to strike a balance between generating returns and managing interest rate risk. They typically have a moderate sensitivity to changes in interest rates, making them suitable for investors who want a potential for higher returns while accepting a moderate level of interest rate risk. For example, Nippon India Low Duration Fund fund has low to moderate risk.

Liquidity

Similar to ultra short-term funds, these funds aim to maintain a reasonable level of liquidity. Investors can typically redeem their units with ease, providing access to their funds when needed.

Diversification

They invest in a diversified portfolio of short-term debt instruments and money market securities and this diversification helps spread risk across various issuers and instruments, reducing the impact of a default by any single issuer. For example, ICICI Prudential Savings Fund has invested in more than 100 companies’ bonds to diversify its portfolio, as of April 19, 2024.

Regular Income

Many low duration funds distribute regular dividends, offering a source of income. Investors seeking regular income can benefit from the interest income generated by the fund's portfolio and provide a stable income stream, making them suitable for income oriented investors.

Interest Rate Risk

Although they are designed to have a lower sensitivity to interest rate movements compared to longer-term debt funds, they are not entirely immune to interest rate risk. If interest rates rise, the value of existing fixed-rate securities in the portfolio may decrease.

Credit Risk

They invest in a mix of debt securities, including corporate bonds and there is a potential for credit risk if the issuers of these bonds default on their payments. This will impact the fund's performance.

Market and Liquidity Risk

In times of market stress or heightened volatility, there may be increased liquidity challenges in the debt markets. If a fund faces redemption pressures or if there is a lack of liquidity in the underlying securities, it can impact the fund's ability to meet redemption requests promptly.

Limited Capital Appreciation Potential

They are primarily focused on providing income through interest earnings rather than capital appreciation. If an investor is looking for capital growth or long-term wealth accumulation, other investment options may be more suitable.

Low duration funds offer a compelling investment option for those seeking higher returns than traditional savings accounts or fixed deposits, with moderate interest rate and credit risk. They are particularly suitable for investors with medium-term financial goals, providing a balance of potential returns and liquidity. However, these funds are not immune to market fluctuations, interest rate changes, and credit risks, which can affect their performance. Overall, low duration funds can be a valuable part of an investment portfolio, especially for those seeking a balance between safety and return with moderate risk tolerance.