Before discussing low-duration funds, it’s important to understand what it is and how it functions.
Low-duration debt funds are those that invest in short-term debt securities, with a portfolio duration between 6 and 12 months.
These funds have a higher interest rate and credit risk compared to overnight or liquid funds as their assets come with a longer term and sometimes, lower credit quality.
Before delving into how low-duration funds work and the best way to choose one for yourself, it’s important to understand the concept of duration, since a fund’s length affects both its investment decisions and the types and amounts of returns it produces. Now let’s take a closer look at low-duration funds.
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Table of Contents
- What is Duration?
- Low Duration Definition-
- What Do These Funds Invest In?
- Sources of Short-term Funds: How to Earn Them
- Advantages of Low-duration Funds –
- Finding the Optimum Low Duration Funds to Invest In – A Guide
- What Investors Should Consider Low-duration Funds?
To evaluate how any change in market interest rates will influence a debt fund’s value, the fund’s duration is calculated. Interest rate risk is another way to explain duration. As the duration grows longer, the fund’s volatility increases, and its interest rate risk heightens.
Establishing a duration involves using a tricky formula and gathering lots of information about the fund’s investments. A general principle that the majority of investors use is to base their estimation of duration on what bonds are held in the fund.
When compared to funds that contain bonds with short maturities, long-term bondholders have longer durations. If a fund holds more lengthy-term bonds it will result in both an extended duration and higher interest rate danger for the fund.
According to SEBI regulations, these funds must have a tenure of 6-12 months. Consequently, these low-duration funds are likely to invest mainly in short-term debt instruments. Therefore, these funds possess a minimal risk of changes in interest rates.
Low-duration funds may invest in any type of debt asset, regardless of credit quality, and can encompass a wide range of investments including money market instruments, corporate bonds, government securities, securitized debt, or allowed derivatives.
Additionally, they often include hybrid products like REITs and units of other mutual funds for diversification purposes.
Low-term funds gain both interest and capital benefits from their debt investments. By investing a part of their resources in bonds with a credit rating of AA or below, which provide higher interest rates, the funds raise their interest proceeds.
Note that lower-rated bonds provide greater yields but also greater default hazards. Most low-duration funds accept some amount of credit risk in return for greater earnings. Also, low-term funds may also produce capital gains.
Fund directors can boost exposure to longer-term bonds when rates are dropping to increase the fund’s value. The high capital worth of extant bonds compensates for the decline in interest income from investing in fresh infusions at lesser rates. Low-duration funds use practices based both on credit risks and interest rate risks to bring forth returns.
Typically, low-duration funds do not own securities that are more than one and a half years in maturity, which makes them carry a moderate amount of interest rate risk.
As such, they can benefit from both sides of the equation; when interest rates go down, the further revenue generated by new bonds is less than the capital gains from existing bonds.
Consequently, these funds decrease their duration to reduce any potential capital losses and receive greater interest on newer bonds. A lower volatility of values is observed with these funds when compared to longer-duration funds.
After the NBFC crisis in 2018; investors have become wary of credit risks because there are not any credit exposure regulations that apply to low-duration funds. Most of them still hold debt though, so this specific fund type is suitable for people who have a middle-ground risk tolerance.
Low-duration funds offer higher returns than liquid funds. These funds have a bigger risk of credit and duration, so they normally outperform ultra-short-duration funds.
Plus, the possibility of large capital gains from possessing bonds with longer maturities makes low-duration funds more likely to succeed in comparison.
Understand the Advantages of Filing Income Tax Returns
If you want to choose the best-low duration funds to invest in, you should consider a return, risk, and expense ratios.
With regard to a low-duration fund that predominantly invests in short-term debt, assessing its performance relies on returns from either the last six months or one year. A fund with commendable performance has greater returns than both its benchmark and its competitors.
In addition, top-notch funds often achieve positive yields. Thus, investors should consider returns garnered over multiple years rather than just the most recent return numbers to ascertain if the fund has stayed at a consistently successful level.
Threat: Low-duration funds are subject to both interest rate uncertainty and credit likelihood. Investors should track the fund’s duration, which is updated each month, to see if it has become more sensitive to interest rate risk.
Examine the fund portfolio composition to determine its bond credit quality as well. A low-duration fund carries a greater chance of default if a large section of its holdings is comprised of lower-grade debt, which might not suit the investor’s risk tolerance.
The expense ratio is the fee a fund charges each year to manage its portfolio. After subtracting the expense ratio, we can calculate the net return on the investment.
Funds with low durations generally feature lower expense ratios, which affects the ultimate return of the investor; therefore, it is essential to keep an eye on this value. It is imperative to understand and gauge any sudden or gradual modifications in the expense ratio.
What to bear in mind before borrowing against gold
Low-duration Funds are only recommended to investors who fulfill the following criteria. Consider investing in these funds if you –
- Invest within a time frame of 3 months or longer.
- Want a regular income?
- Looking for an alternative to traditional deposits that gives better liquidity and higher returns from the market?
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