A low duration fund is also a debt mutual fund, which is primarily invested in a fixed-income security with a macaulay duration between 6 and 12-months. The funds are suitable to investors who want to get higher rate of returns than overnight funds or liquid funds and have a comparatively less interest rate risk.
The low duration funds are highly liquid and thus, they are used in achieving short-term financial objectives. They invest in instruments such as commercial papers, certificates of deposit, and corporate bonds. Low duration funds appeal to conservative investors because they offer a balance between risk and returns. Before investing, you should always look at the credit rating, yield to maturity and the expense ratio.
Understanding How Low Duration Funds Work for Short-Term Returns
Low duration funds work in such a way that they invest in debt and money assets, which have a maturity of 6-12 months. Such investments include corporate bonds, commercial papers, certification of deposits, treasury bills and others. These instruments attract higher returns compared to those derived from bank deposits; however, they also have an increased risk associated with them.
Low duration funds have an objective of generating income and capital gains by holding the securities till their maturity or selling the securities in the secondary market. The fund manager decides on the allocation of the portfolio depending on market conditions, the credit quality of the issuers and the liquidity of the instruments. Also, the fund manager monitors the performance of the portfolio and makes modifications as needed.
What is the Suitability of Low duration funds
This is the best type of funds, it suits the investors who need returns at fixed rates within a short time of six to twelve months. They provide a good combination of liquidity, fair returns and little exposure to interest rate fluctuations.
Who Should Invest in Low Duration Funds
The investors that can comfortably invest in these funds are:
- Short term funds are thought to be the most appropriate funds for investors who intend to invest beyond three months.
- Very short term investors should, instead, consider overnight or liquid funds.
- You can use these low duration funds to keep some extra money temporarily e.g. in case of a house sale or a yearly bonus or savings toward some future small financial demands.
- Investors with the ability to tolerate moderate levels of risk may consider investing part of their portfolio in these funds and putting in a systematic withdrawal plan (SWP) to generate a regular income.
- Smaller-risk investors may find low duration funds more appealing alternative to bank deposits due to their greater liquidity and potential market returns.
Important Factors to Consider While Investing in Low Duration Funds
Investors must keep a few factors in mind when selecting the most suitable low duration debt funds to make sound decisions:
Risk: These are mostly low risk funds but not entirely risk-free. They experience risk of interest rates, credit and liquidity. One should learn more about the credit quality of the fund and about how it acts in the market.
Returns: Low duration funds tend to earn higher returns as compared to fixed deposits and other short term investments. There is no guarantee of earnings and the returns may differ depending on the situation of the market, the plan of the fund and the performance of the securities.
Expense Ratio: The Expense ratio of a fund directly affects the returns on investment by investors. It is prudent to opt for funds that have a low expense ratio to generate higher net returns.
Performance Track Record: Consider the old track record and the recent track record, compare them to the benchmark and the average in the category. Confirm the portfolio allocation, the yield, average maturity and credit ratings are as per the risk tolerance and investment objective.
When choosing an appropriate low duration fund, one should strike a balance between the risk, the return, and the cost. Ensure at all times that the profile of the fund that you are investing in suits your short-term money objectives and liquidity requirements.
Major Advantages of Investing in the Low Duration Fund
These are some of the major advantages of investing in the low duration mutual funds –
Active portfolio management: Fund managers strive to change portfolios according to market fluctuations to offer optimum returns.
Better returns: The best low duration mutual funds tend to provide an improved return than certain other types of debt funds. They assume additional credit risk and hold short term bonds that do better.
Moderate risk: Low duration funds have a moderate risk rating because they do not hold securities beyond 6 to 12 months. Due to this fact, such money is less vulnerable to the risk of inflation as well as to the risk of fluctuation in interest rates.
Mode of investment: The lump sum and SIP are the two modes of investing in low duration mutual funds. The former is a straightforward plan, and the latter is a systematic investment plan where you can invest money at fixed intervals.
Key Risks Involved in Low Duration Fund Investments
Credit Risk: When low duration funds invest in lower-rated securities to increase returns they face credit risk. The fund may suffer losses in case the issuer defaults on making the payments.
Interest Rate Risk: The interest rate risk of low duration funds is lower compared to long duration debt funds but they are still not totally immune to interest rate fluctuations. A sudden drastic rise in interest rates may lead to a decline in the value of the underlying securities.
Liquidity Risk: During times of market downturn, it may be hard to sell some debt securities without incurring large losses, a factor that brings out liquidity risk.
Inflation Risk: Low duration funds may fail to keep up with inflation particularly where inflation is increasing. This has the potential to decrease the buying power of returns in the long run.
How to Evaluate a Low Duration Fund
When investing in low duration mutual funds, it is important to focus on three aspects which are returns, risk, and expense ratio.
Returns: Since these funds invest in short-term debt it is beneficial to examine the rate of their performance in terms of 6 months to 1 year. A good fund will continually outperform its benchmark and comparable funds. Do not only concentrate on current returns, look at the history of the fund in different years and ensure that the fund performs well.
Risk: Low duration funds are associated with interest rate risk and credit risk. Monitor the average duration (which is published monthly) of the fund to determine whether it is assuming greater interest rate risk. You should also consider the credit quality of investment funds which may have higher returns but at the same time, have an increased risk of default. Ensure that the risk level of this fund is relative to your risk tolerance.
Expense Ratio: This is the annual charge deducted from your profits earnings. Low duration funds usually perform with reduced expense ratios but any increment translates into a reduction of your net earnings. Monitor the variation in the expense ratio to determine how it impacts your total returns.
How to Invest in Low Duration Funds?
- Determine Your Investment Objectives: Determine what you expect of your investments, the amount of risk you can take and your investment timeline. This will prevent you from choosing the most suitable low-duration fund that will meet your objectives.
- Explore and contrast funds: Research various low-duration funds choices and evaluate them based on their past performance, rates, credit ratings and their sensitivity to changes of interest rates. And use prepared materials like fund fact sheets and ratings on independent organisations to make smart decisions.
- Diversify Your Investments: Diversification is one of the ways of mitigating risk. Consider investing in a range of low-duration funds based on the money of various companies so that possible losses can be limited.
- Watch Your Investments: You should get into the habit of checking your portfolio on a regular basis to ensure it’s still in line with your investment objectives. Monitor and update yourself on the interest rates and the events that may influence your investments.
- Seek Professional Advice: You may want to consult a financial expert when you are not quite sure what low-duration funds you should choose.
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