Investing in low-duration mutual funds has emerged as a timely opportunity as interest rates fall. These funds balance stability and returns, making them an ideal choice for those looking to park surplus funds while aiming for better yields than traditional savings instruments.
When interest rates fall, bond prices rise which benefits low-duration funds as they hold short-term bonds with lower sensitivity to rate changes. These funds also offer better returns than liquid or ultra short-term funds while maintaining relatively low risk. Low-duration funds suit conservative to moderately risk-tolerant investors looking for better returns than fixed deposits but without locking in capital for long periods.
Attractive returns
Holding low-duration funds for up to a year could generate returns of 7.75-8%, making them a better alternative to liquid funds or fixed deposits. These funds, which invest in short-term debt instruments, are well-positioned to gain from both falling rates and the current steep spreads between overnight rates and short-term bond yields.
Nirav Karkera, head, Research, Fisdom, says as rates decline and liquidity improves, these spreads are likely to compress, boosting the prices of existing higher-yielding bonds and leading to potential capital appreciation. “This combination of attractive accrual and scope for mark-to-market gains makes low-duration funds a smart choice in today’s environment,” he says.
Low-duration mutual funds, which typically hold debt securities with maturities between 6-12 months, offer a sweet spot for investors who want to tactically benefit from the initial yield compression while keeping duration risks modest. Sonam Srivastava, founder, Wright Research PMS, says these funds are especially attractive now because they provide higher accrual income compared to ultra-short funds, and are well-positioned to benefit from mark-to-market gains as short-term yields start to soften ahead of the policy pivot.
Moderate risk exposure
Low-duration funds primarily allocate investments to short-term debt instruments and money market securities, maintaining a portfolio duration of six to 12 months. These funds are well-suited for investors seeking moderate risk exposure with a short to medium-term investment horizon. They offer a balance between stability and returns, making them an ideal choice for those looking to park surplus funds while aiming for better yields than traditional savings instruments.
Soumya Sarkar, co-founder of Wealth Redefine, an AMFI-registered mutual fund distributor, says low-duration funds are best suited for conservative investors parking money for 6 months to one year. “Currently, they are a sweet spot for investors seeking stability with slightly higher yields in a falling rate environment. Investors looking for higher returns than bank fixed deposits but with low risk should invest in low-duration funds,” he adds.
What to keep in mind
Low-duration funds are influenced by interest rate movements, where falling rates can lead to capital gains, while rising rates may impact returns. Additionally, credit risk plays a role, as some funds invest in corporate bonds with varying credit ratings, making it crucial to check the portfolio’s credit quality.
Abhishek Banerjee, founder & CEO, Lotusdew Wealth & Investment Advisors, says mismanagement of solvency can lead to serious issues. “It is better to split the investment across a few fund houses to diversify operational and credit risk,” he says.
Investors must check if the fund holds mostly AAA-rated bonds to minimise default risk. It is important to review the holdings to check if there is a large allocation to off-benchmark instruments to enhance yield and take that risk into account when choosing.
The ideal investment horizon is a 6- to 18-month timeframe. So, aligning the fund’s duration with one’s investment horizon is critical to reduce reinvestment risk and ensure effective capital planning.
Liquidity needs should also be evaluated. While low-duration funds offer better liquidity than long-duration debt funds, early withdrawals may attract exit loads. Investors must review the fund’s historical performance, risk-adjusted returns, and portfolio composition at the time of selecting the fund to invest.
Low duration funds are used to park money, waiting on the sidelines to find market opportunities. Costs are very important in a low-duration fund and choosing a low total expense ratio and using direct funds is critical.