Introduction
Low duration funds offer investors a balanced approach, positioned between ultra-short-term and traditional bond funds. Investing primarily in bonds with maturities of 6 months to a year, they provide slightly higher returns than ultra-short options while emphasising safety through high-quality debt securities. Here, we’ll explore the features, types, risks, and potential returns of Ultra Short Funds.
What are Low Duration Funds?
Low duration funds are a type of mutual fund that sits between ultra-short term funds and traditional bond funds. They primarily invest in bonds with maturities ranging from 6 months to a year, offering the potential for slightly higher returns compared to ultra-short term funds. By emphasising high-quality debt securities, low duration funds manage risk effectively while providing investors with high liquidity due to the short maturities.
How do Low Duration Funds work?
Low-duration funds offer a bridge between ultra-short-term funds and longer-term bond funds by focusing on high-quality debt instruments with maturities ranging from 6 months to 1 year. These instruments, such as commercial paper and Treasury Bills, carry slightly more risk than ultra-short term options, but still prioritise safety. Fund managers allocate investor funds into this debt, distributing earned interest and reinvesting principal upon maturity. This strategy provides a balance between safety and yield, offering investors moderate returns and high liquidity.
Features of Low Duration Funds
Features of Low Duration Funds are:
- Short Duration Focus: These funds prioritise debt securities with short maturities, typically between one to three years, reducing interest rate risk compared to longer-term bonds.
- Lower Interest Rate: Due to their shorter duration profile, low duration funds exhibit lower sensitivity to interest rate changes, resulting in reduced price volatility and NAV impact compared to longer-duration bond funds.
- Capital Preservation: Emphasising capital preservation alongside modest returns, these funds offer stability and liquidity, making them suitable for investors with shorter horizons or those aiming to mitigate interest rate risk.
- Income Generation: Despite their focus on safety, low duration funds aim to generate income for investors through interest payments from underlying debt securities, providing a source of regular income.
- Diversification: By maintaining diversified portfolios across government and corporate bonds, these funds spread risk and minimise the impact of defaults or credit events on the overall portfolio.
- Risk Management: Fund managers actively manage various risks, including credit risk, interest rate risk, and liquidity risk, employing thorough analysis and portfolio adjustments to optimise returns while safeguarding investors’ capital.
- Liquidity: Offering high liquidity, investors can redeem their units at any time without significant costs or penalties, providing flexibility and quick access to funds when necessary.
- Tax Efficiency: Gains from low duration funds held for over three years are taxed at the investor’s applicable income tax rate, similar to other debt funds, ensuring tax efficiency. Short-term capital gains are also taxed accordingly.
Risks and Returns
Before investing in Low Duration Funds, it’s important to understand both the potential benefits and drawbacks:
Returns
- Stable and Competitive Yields: Low-duration funds target consistent returns over the short to medium term, offering yields that are competitive with traditional savings accounts and may even provide slightly higher returns. This strategy prioritises income generation through regular interest payments from the underlying debt securities.
Risks
- Market Fluctuations: Although low-duration funds benefit from shorter maturities that are less sensitive to interest rate changes compared to longer-term bonds, they are not entirely immune. Rising interest rates or broader market fluctuations can still impact the value of the underlying securities and the fund’s performance.
- Credit Risk: While low-duration funds primarily invest in high-quality debt, there’s always a slight possibility of default by the issuers, even though it’s uncommon. This credit risk can lead to potential losses for the fund and investors.
- Liquidity Risk: In rare instances of market-wide stress, there’s a possibility of limited liquidity, which could affect the fund’s ability to meet redemption requests promptly.
- Inflation Risk: As with most fixed-income investments, low-duration funds might not always keep pace with inflation. Over time, this could result in a slight erosion of purchasing power.
Conclusion
Low-duration funds offer a prudent investment option, striking a balance between safety and moderate returns. These funds are a compelling choice for risk-averse investors or those with short-term goals. Positioned between ultra-short-term funds and traditional bond funds, they prioritise capital preservation while offering liquidity and income generation through regular interest payments. Understanding the associated risks and potential returns is crucial for informed investment decisions.
Disclaimer: The views expressed here are of the author and do not reflect those of Dhanvantree. Mutual funds are subject to market risks, please read the scheme documents carefully before investing.