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What are Low Duration/Ultra Short Duration/ Short Duration/Medium Duration funds?

When it comes to relatively low risk debt mutual funds, the funds with a lower/medium maturity period may be ideal because they tend to carry lesser interest rate risk. Amongst the types of debt funds with a lower/medium maturity, you may consider four categories of debt funds - low duration, ultra-short duration, short duration and medium duration mutual funds. How are they different? Well, the basic categorization is in terms of the maturity profile of the funds

Ultra-short Duration:

The mutual fund portfolio has a Macaulay Duration of 3-6 months

Low Duration:

The mutual fund portfolio has a Macaulay Duration of 6-12 months

Short Duration:

The mutual fund portfolio has a Macaulay Duration of 1-3 years

Medium Duration:

The mutual fund portfolio has a Macaulay Duration of 3-4 years

But how do you decide which one to invest in? We’ll get to that. Let us first understand the concept of duration

What is Duration/Macaulay Duration?

The duration of a debt fund is expressed in terms of a number of years/months. Duration is affected by the% of fluctuation in a fund’s value with the fluctuation in interest rates. Hence, the higher the duration, the more will be its sensitivity to interest rate fluctuation, and the greater will be the interest rate risk. Typically, funds with a higher duration are invested in securities of longer maturities and vice versa. By this logic, short-duration funds will be exposed to higher interest rate risk when compared to low duration fund and so on.

But this doesn’t mean that every security held by these mutual funds have the exact same duration as the portfolio duration. For example, it is not true that all the securities in a low duration debt funds will have a Macaulay duration of 6-12 months. The duration of the fund represents the weighted average of the duration of all the securities together. So, while some bonds held by the fund may have a duration of 3 months, some can even have a duration of 1 year.

How do these funds work?

If you know how debt funds work, these funds work in no different way. What differs is the maturity period, as mentioned above. There are no restrictions on the credit quality of the securities that these funds can invest in.

The returns can be attributed to the interest earned from the underlying securities and the capital gains/losses. The fund managers may increase the exposure to longer maturity bonds when the interest rate is falling and vice versa. This gives an opportunity to generate higher yields. There can also be a variety of credit qualities in the securities held by these funds.

Features of low/short/ultra-short/medium duration funds

1. Duration:

These funds are apt for your investment goals that are in tandem with the duration offered by the funds, respectively. For example, if you are investing for the quarterly fee of your child’s school, then ultra-short duration fund may be apt for you; whereas if you are investing for a short vacation 6-12 months down the line, a low duration fund may be more suitable. And so on.

2. Risk:

The ultra-short duration and low duration funds typically carry low to moderate interest rate risk and a short-duration fund carries moderate interest rate risk.

3. Alternatives to traditional saving avenues:

These funds can be ideal alternatives for the money parked in your otherwise saving avenues or as emergency funds. While maintaining liquidity, these funds may provide you with an opportunity of earning possibly higher returns.

Things to keep in mind

Firstly, we would like to reemphasize the fact that there is no regulation on the kind of credit quality that these funds are investing in. Hence, it becomes necessary for the investor to check the portfolio and ensure that it matches your risk appetite. While there can be many best low duration debt funds or best short term debt funds being advertised, you have to find the one that matches your investment objectives; be it in terms of the credit quality the fund invests in or the investment strategy of the fund. Secondly, all types of debt funds, depending on their duration and credit quality of the portfolio, may be subject to a certain level of interest rate risk and credit risk, respectively. Hence, select carefully. You can know more about the risks in debt funds Here

The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their associates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of lost profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this document.

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