There was a time when investing extra cash and profits in bank Fixed Deposits was the norm. A few years back, FDs were considered as the best option to earn interest while making sure that your money is safe. However, with mutual funds coming to the fore in recent years, the scenario has completely changed. The biggest perk of mutual funds is that they consist of options like low duration mutual funds, which enables investors to park their funds for a short duration and earn profits.
Low duration mutual funds not only gained the attention of retailers but have also become popular amongst non-individual investors and business owners. Low duration mutual funds facilitate better liquidity than Fixed Deposits, making them the preferred option for business owners who want to generate returns from their idle sitting cash without paying any exit load.
If you are keen to know how low duration mutual funds can help you make more profit for your business, then this guide is a must-read for you.
What are Low Duration Mutual Funds?
Low duration funds are basically open-ended debt funds that invest in debt securities and money market instruments. The Macaulay duration of the mutual fund investment is between 6 to 12 months. In case you are not aware, then Macaulay’s duration is the weighted average of the time during which the cash flows from a bond. It is measured in years.
How do Low Duration Funds work?
According to SEBI guidelines, low duration funds have to maintain mutual funds investment duration of 6-12 months. This means that low duration funds are allowed to invest in short term debt securities only. This includes government securities, money market securities, hybrid instruments, corporate bonds, permitted derivative instruments and other mutual funds units. It is also important to note here that since low duration funds invest in short duration securities only, they have low-interest rate risk.
What are the sources of earnings for Low Duration Funds?
The source of earnings for Low Duration funds is the same as debt securities. Their earnings are from capital gains as well as interest. The interest-earning is generated from holding a part of their assets in bonds that have credit ratings of AA or lower. These bonds pay higher interest rates in comparison to lower-rated bonds that generate more returns.
Low duration funds take credit risk to yield higher returns to investors. They can generate a capital gain by increasing exposure of the funds to longer maturity bonds. This aids in boosting the value of the fund. Hence, the low duration funds generate returns by using both credit risk and interest risk strategies.
Benefits of investing in Low-Duration Funds?
If you are investing in low duration funds, then your money will be exposed to a moderate level of risk. Since these funds usually do not hold a maturity that is higher than 1-1.5 years, therefore, you can generate fair returns even with the interest rate fluctuations in the market. To understand this, consider that the interest rates are going down but your investment is at lesser risk. The loss of interest income on fresh bonds will be lesser than the capital gains that you will receive on existing bond values.
Now, suppose the interest rate increases again, then you are exposed to lesser risk as the fund will reduce the tenure so capital loss reduces. This means that you will earn higher interest rates on the new bonds. Thus, we can clearly see that investment in low duration funds is less volatile than in the case of longer-duration funds.
The performance of low duration mutual funds often surpass the liquid funds as they have more duration exposure and are allowed to take a credit card. Low duration funds can also be turned into ultra-short duration funds as there are chances of low duration funds making higher capital gains by holding longer maturity bonds.
Who should invest in Low Duration Mutual Funds?
Investors who are looking for other investment options than bank deposits
Investors who can bear moderate risk can find the low duration funds a better investment option than fixed deposits. Low-duration funds offer better returns and do not charge any exit load.
Investors with short-term investment goals
Low duration funds are the right investment option for those who have short-term investment goals or who have an investment horizon of 3 months. Please also note that for a duration longer than 3 months, low duration funds offer high returns but in exchange for a small increase in risk. Investors who are business owners or entrepreneurs can use low duration funds for parking surpluses which they later want to invest in purchasing inventory or launching a new product.
Investors who want to create a stream of income flows
Low duration funds can help generate a regular stream of income with capital gains and interest earnings. Investors with a moderate risk appetite can allocate their surplus cash to these funds and use SWP to get profits after a pre-determined time.
What To Consider Before Investing In Low Duration Funds?
1. Low duration funds are exposed to low-quality debts –
A large default can lead to fund values dropping sharply. In this case, investors would have to choose between selling out a loss or holding a discounted unit. To avoid this, it is imperative for investors to track the rating profile of the debt portfolio and issuer-wise exposures.
2. Low duration fund values are exposed to volatility –
It is recommended that investors should recognize the interest rate risk and make sure it matches their goals and risk appetite. For instance, it is not a good idea to invest emergency or contingency funds in low duration mutual funds.
Tips to Find The Best Low Duration Funds
1. Return –
Since low duration invests essentially in short-term debts, it is crucial to assess its performance based on 6 months or 1-year returns. A well-performing low duration mutual fund is one that is able to beat its benchmark as well as the returns earned by other low duration funds. So, don’t just go through the recent numbers, examine the returns generated in previous years to make sure that the fund continuously performs well.
2. Risk –
Low duration funds are exposed to both credit risk and interest rate risk. Investors should track the duration of the fund to determine if the fund’s interest rate risk has increased or decreased. The low duration funds which spend a significant part of their assets in lower-rated debt face a higher risk of default, which may not align with the investor’s risk tolerance.
3. Expense Ratio –
The expense ratio is the amount charged by the fund for managing the portfolio. The net return is calculated after subtracting the expense ratio from the return generated. Typically, low duration funds have low expense ratios. However, it is essential to keep track of the expense ratio as it has a role to play in the final return.
Low Duration Mutual Funds Taxation
When investors invest in low duration mutual funds, they earn capital gains and dividend income.
Now first let’s understand what are capital gains?
Capital gains are the difference between the buying and selling price of the units. The rate at which capital gains are taxed depends on the duration for which the investor holds the mutual funds-
- Short term capital gains –
If you keep your money invested for a period of up to 3 years, capital gains are regarded as short-term gains and taxed according to the income tax rate to which you belong.
- Long term capital gains-
If you sell the unit after investing it for more than 3 years, it is regarded as a long-term capital gain. In this case, the investor gets the benefit of “indexation”, because of which your taxable amount is reduced. Currently, long term capital gains are taxed at a rate of 20%.
It is also important to note here that investors are not taxed for the dividend income.
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In A Nutshell,
- Low duration funds are basically open-ended debt funds that invest in debt securities and money market instruments.
- According to SEBI guidelines, low duration funds have to maintain investment duration between 6-12 months. This means that low duration funds are allowed to invest in short term debt securities only.
- The sources of earnings for low duration funds are capital gains and interest.
- Average risk and high returns are some of the benefits of low duration funds.
- Investors with short-term investment goals or who want to create a stream of income flows can invest in low duration mutual funds.
- Before investing in low duration mutual funds, it is important to know that they are exposed to low-quality debts and volatility.
- It is crucial to understand the risk, return and expense ratio before investing in low duration mutual funds.
- If you are planning to park your business’s idle cash in mutual funds, then Shootih is the best platform.
- Shootih also provides you with an aggregated view of your business transactions on the same platform. Hence, enabling you to track, manage and grow your wealth through a single platform.