Before any discussion regarding low-duration funds, one must be clear about what it is and how it works.
Low-duration debt funds are those that invest in short-term debt securities, with portfolio duration of between 6 and 12 months. Low-duration funds have assets that come with a longer term and can have a lower credit quality in comparison to overnight or liquid funds. Therefore, they have more interest rate and credit risk.
Now let’s look at how low-duration funds work. Understanding the notion of duration is crucial before learning how low-duration funds operate and how you can choose the best low duration fund for yourself. Knowing about duration is important since a fund’s length influences both its investment choices and the kind and volume of returns it generates.
What is Duration?
The duration of a debt fund assesses the degree to which changes in market interest rates affect the fund’s value. Another name for the duration is interest rate risk. Therefore, the fund value will be more volatile and its interest rate risk will be higher the longer the duration. The lengthy process of determining duration necessitates a complicated formula and extensive information on the fund’s investments. A decent rule of thumb for the majority of investors is to base their estimation of duration on the bond maturities held by the fund. Especially in comparison to funds that hold bonds with lesser maturities, long-maturity bond holdings have longer durations. The duration of a fund and its interest rate risk both grow if it holds more long-term bonds.
Low Duration Definition-
These funds must have a duration of six to twelve months following SEBI regulations. As a result, chances are that low-duration will invest exclusively in short-term debt securities. Low duration funds, therefore, carry a low risk of interest rate.
Where Do These Funds Invest?
Low-duration funds may invest anywhere; there are no limitations on the kind of debt assets or the level of credit quality that they may hold. To diversify their holdings, these funds invest in a variety of securities, such as money market instruments, corporate bonds, government securities, securitized debt, hybrid products like REITs, allowed derivatives, or other mutual fund units.
Earning Sources of Low-duration Funds –
Both interest and capital gains from their debt instruments are sources of income for low-duration funds. By investing a portion of their assets in bonds with credit ratings of AA or lower, which have comparatively higher interest rates, these funds increase their interest income. Keep in mind that lower-rated bonds offer higher yields but also higher default risks. The majority of low-duration funds accept some credit risk in exchange for better returns. Capital gains may also be produced by low-term funds. Fund managers will increase exposure to longer-term bonds when interest rates are falling to boost the fund’s value. The increase in the capital value of existing bonds will more than offset the loss of interest revenue from investing in fresh inflows at lower interest rates. To create returns, low-duration funds employ methods based on both interest rate risk and credit risk.
Merits of Low-duration Funds –
Low-duration funds typically do not hold securities with maturities greater than one and a half years, thus they have a moderate level of interest rate risk. They are in a win-win situation as a result because when interest rates drop, the loss of interest revenue on new bonds is significantly less than the capital gains on the value of existing bonds. The funds reduce their duration when interest rates rise to reduce capital losses while simultaneously earning greater interest rates on new bonds. As a result, low-duration funds have less volatility in their value than longer-duration funds. Investors have been concerned about credit risk since the 2018 NBFC crisis, in large part because low-duration funds do not have credit exposure norms. The majority of these funds do hold debt, though, and as a result, the fund category is still appropriate for investors with medium risk tolerance.
Low-duration Funds offer comparatively higher returns. Because low-duration funds are permitted to take on more credit and duration risk, they typically outperform liquid funds. Due to the possibility of bigger capital gains from owning bonds with longer maturities, low-duration funds have the potential to outperform ultra-short duration funds.
How to Find the Best Low Duration Funds to Invest in –
Return, risk, and expense ratio should all be taken into account if you want to find the best low duration fund to invest in.
Return: Since a low-duration fund primarily invests in short-term debt, it is acceptable to evaluate its performance using returns for the previous six months or one year. A low-duration fund with strong performance will outperform both its benchmark and the returns of similar peer funds. What’s more, the top-performing funds routinely generate positive returns. Therefore, investors should look at returns produced in previous years rather than being wowed by the most recent return figure to ensure that the fund has consistently performed well.
Risk: Interest rate risk and credit risk both exist in low-duration funds. Investors should monitor the fund’s duration, which is reported each month, to see whether the fund’s susceptibility to interest rate risk has increased. To evaluate the credit quality of the bond holdings of your fund, the portfolio’s composition should also be monitored. A low-duration fund faces a larger chance of default if a sizable portion of its assets is allocated to lower-rated debt, which may not be compatible with the investor’s risk appetite.
Expense Ratio: The amount a fund charges annually to manage the portfolio is known as the expense ratio. After deducting the expense ratio, the net return on the investment is computed. Low expense ratios are typical of low-duration funds. The final investor return is affected by this characteristic, hence it is crucial to monitor it. It is necessary to examine and comprehend an increase in the expense ratio, whether it is sudden or gradual.
Who Should Invest in Low-duration Funds?
Only those investors who fulfill the following requirements should invest in Low-duration Funds. Invest in these funds if you –
- Have an investment horizon of 3 months or more.
- Want a regular income.
- Want an alternative to bank deposits to get better liquidity and higher market-linked returns.