Low Duration Funds

Mutual funds are increasing in popularity as a viable investment option with the new age investor. Of all the options, debt funds are mostly preferred for their lower risk and decent returns. Low Duration Funds are a type of debt fund that invests in short-term debt securities. They are suitable for investors who want to earn regular income but look for an alternative to bank deposits for a short investment duration.

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Let us explore what Low Duration Funds entail and their various features that help during evaluation.

What are Low Duration Funds?

Low Duration Funds are open-ended debt funds that invest across short-term debt and money market securities with a maturity duration (Macaulay duration) between 6 to 12 months. Comparatively, they have a higher maturity period than liquid funds but lower than that of Short/Medium/Long Duration Funds.

These funds invest in low-duration fixed instruments that offer moderate liquidity and returns. They are also better for diversifying a financial portfolio. However, you must note that LDFs have a higher monthly or lump sum investment range than other schemes.

Key Features of Low Duration Funds

Investors should be familiar with some key features of Low Duration Funds, such as the following:

  1. Fund duration

    As per SEBI guidelines, fund duration for LDFs must be between 6 to 12 months. Since the duration is short, they present a lower interest rate risk.

  2. Investment pattern 

    These funds invest across a wide base of debt securities, including money market securities, corporate bonds, and government securities.

  3. Earnings

    Low Duration Funds earn from interest and capital gains from their diversified portfolio investments. They earn interest by holding part assets in higher interest rate bonds having AA or lower credit ratings.

    Note: Low Duration Funds entail some credit risk for ensuring higher returns. At the time of falling interest rates, any loss on account of interest income from fresh bonds is compensated through gains in the capital value of current funds. Low Duration funds use credit risk and interest rate risk strategies for earning returns.

What to Know Before Investing in Low Duration Funds?

Investors must analyze a Low Duration Fund based on the following parameters:

  1. Return

    Since Low Duration Funds are short-duration debt funds, they should be evaluated based on their performance and returns generated in the 6–12-months period. Investors should also track the previous years’ returns to understand the fund’s historical performance and return generation.

  2. Risk

    These funds entail both interest rate and credit risks. Everyone must track the fund duration to analyze the fluctuations in its interest rate. To evaluate the fund’s credit risk, all investors must track their portfolio composition.

  3. Expense Ratio

    Low Duration Funds typically have low expense ratios. However, an investor should be aware of the changes in expense ratio as it impacts the final return on their investment.

  4. Investment Goal

    These funds are suitable for investors with short-term investment goals having an investment horizon of notably 6–12 months.

Pros of Low Duration Funds

This section explores the significant benefits offered by the fund. Take a look.

  1. Higher returns

    Low Duration Funds can be expected to deliver 2–3% higher returns than liquid funds, mainly in a falling interest rate situation. The funds get greater credit and duration exposure than liquid funds. Also, they outperform ultra-short duration funds by generating higher capital gains through longer maturity bonds. This makes them a good short-term investment option.

  2. Less volatility

    Low Duration Funds have the least volatility among all debt funds showing interest rate or credit risk. It is because volatility increases as the duration of a fund increase making debt funds of other durations and gilt funds more volatile.

  3. Moderate risk

    Low Duration Funds entail moderate interest rate risk as they have a holding period between 6–12 months. These funds are beneficial under falling interest rates. 

    In a scenario of rising interest rates, low duration funds cut the duration period to reduce capital losses and earn higher interest rates through fresh purchases. They are suitable for investors who have a moderate risk appetite.

Cons of Low Duration Funds

This section highlights the downsides to the fund. These are also essential from an investment point of view.

  1. Credit Risk

    Credit risk refers to the risk of default. This is a significant drawback of Low Duration Funds as they have a higher credit risk as compared to liquid funds. 

  2. Interest risk

    Low Duration funds entail moderate interest rate risk, as they have a shorter holding period.

Eligibility

Low Duration funds are suitable for investors who want a regular income and have a moderate risk appetite. They prefer to stay invested for at least a year to achieve their short-term financial goals.  Such investors also look to earn higher than traditional fixed instruments like savings or fixed deposits.

Taxation on Low Duration Funds

Low Duration Funds earn interest and capital gains for their investors. Capital gain is taxable as per the Income Tax Act, 1961.

  • For a fund holding period of under three years, the short-term capital gain is taxed as per the income tax slab bracket of the investor.

  • For a fund holding period of three years or more, long-term capital gains are taxed at 20% with indexation benefit.  

Note: Taxation rules are subject to changes in Tax Laws.

In Conclusion 

Low Duration Funds invest in short term or duration fixed investment instruments that offer moderate liquidity and returns. Your portfolio is also diversified under low duration funds with investments in different debt and money market instruments like corporate bonds or deposits. 

No matter how lower the risks are presented under low duration funds, you must always carry 0ut your research before making the final investment decision. It is the best way to go forward with any type of investment, especially in funds or the stock market.

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