In today’s changing financial landscape, where interest rates are moving downward, investors are looking for safer and more rewarding short-term options. For many, fixed deposits (FDs) have been the go-to choice. But now, low-duration mutual funds are gaining attention due to their better returns and low risk.
Let’s understand how these funds work, why they are a better option than traditional FDs in certain scenarios, and what you should keep in mind before investing.
What Are Low-Duration Mutual Funds?
Low-duration mutual funds are a type of debt mutual fund that invest in short-term debt instruments. These instruments include commercial papers, treasury bills, certificates of deposit, and short-term corporate bonds. The maturity period of the portfolio is usually between 6 to 12 months, making them suitable for short-term investments.
These funds aim to provide better returns than liquid funds and fixed deposits, without taking too much risk. They are less volatile compared to long-term debt funds, as their exposure to interest rate changes is lower.
Why They Perform Better When Interest Rates Fall
In a falling interest rate scenario, bond prices usually go up. Low-duration funds benefit from this trend because they hold short-term bonds. While they may not react as sharply as long-term bonds, they still gain from the increase in bond prices.
This means investors can earn not only regular interest income but also capital gains. The total returns can range from 7.75% to 8% annually, which is significantly better than the current FD rates in most banks.
Expert Opinions Add Confidence
Experts suggest that the current environment is ideal for these funds. According to Nirav Karkera, Head of Research at Fisdom, “When interest rates fall, high-yield bonds become more attractive, pushing their prices up. Low-duration funds that hold these bonds can benefit from capital appreciation.”
Sonam Srivastava, founder of Wright Research PMS, adds, “These funds are positioned better than ultra-short duration funds because they offer slightly higher returns without taking much extra risk.”
Risk Level Is Moderate, But Stability Is a Plus
Low-duration funds carry moderate risk. Since their holdings mature quickly, any changes in interest rates don’t hurt them much. Compared to equity funds or even long-term debt funds, their performance remains stable. They offer a balance between return and risk that makes them a reliable choice for conservative investors.
Ideal Time Horizon: 6 to 18 Months
These funds are best suited for people looking to park their money for a short time, ideally between 6 to 18 months. If you have money set aside for buying a house, paying education fees, or making any big purchase in the near future, these funds offer better value than simply keeping the money idle or locking it in FDs.
Soumya Sarkar, Co-founder of Wealth Redefine, says, “If you are sure about needing your funds within a year or so, low-duration funds can give you better yields with decent liquidity.”
Important Things to Check Before Investing
1. Impact of Interest Rate Changes
These funds benefit when interest rates fall. But when rates start rising, the capital gains could reduce. It’s important to track the RBI’s stance on monetary policy.
2. Credit Risk in the Portfolio
Some funds may invest in lower-rated corporate bonds to boost returns. This adds a level of credit risk. Always check the credit quality of the holdings. Preference should be given to funds with more AAA-rated securities.
3. Expense Ratio
Always choose funds with a low expense ratio. Opt for direct plans over regular ones, as they come with lower management costs. This ensures that your returns are not eaten up by high charges.
4. Fund House Reputation
Do not invest all your money in a single mutual fund company. Diversify your investments across different Asset Management Companies (AMCs) to lower risk.
5. Liquidity and Exit Load
Most low-duration funds offer good liquidity and do not have high exit loads. But it’s still wise to check the exit load terms before investing.
Why Not Just Stick to Fixed Deposits?
Fixed deposits are definitely safe, but their returns are currently not very attractive. Most banks offer between 5.5% to 7% on short-term FDs. Also, FD interest is fully taxable, which reduces your real return if you are in a higher tax bracket.
On the other hand, low-duration mutual funds offer returns close to 8% with better tax efficiency. Debt mutual funds held for more than 3 years used to get indexation benefits, but even after taxation changes, short-term funds may still provide better post-tax returns depending on your tax slab.
Moreover, in terms of flexibility, mutual funds are more liquid, and their returns are market-linked, which allows some scope for better performance in the right conditions.
Where Do These Funds Invest Exactly?
Low-duration mutual funds usually invest in:
- Treasury Bills (T-Bills)
- Commercial Papers (CPs)
- Certificates of Deposit (CDs)
- Short-term corporate bonds
- Government securities with short maturity
These instruments are generally low risk and have a clear maturity timeline. Fund managers actively select a mix to balance risk and return while keeping the portfolio duration low.
Taxation on Low-Duration Funds
As of the latest tax rules, gains from low-duration mutual funds are treated as short-term capital gains if held for less than 3 years. These gains are added to your income and taxed as per your income tax slab.
So, if you’re in the 20% or 30% bracket, the tax may be a bit higher. But since these funds provide better gross returns compared to FDs, the net returns may still be more favourable.
Also, with no TDS (Tax Deducted at Source) on mutual fund redemptions, you get full returns credited and pay tax only while filing your returns.
Who Should Consider Low-Duration Funds?
- Salaried individuals with upcoming expenses in the next 6-18 months
- Retired investors looking for better returns than FDs without high risk
- Business owners who want to park idle cash with easy liquidity
- Young investors saving for short-term goals
These funds suit anyone who wants capital protection along with slightly better returns. They don’t offer massive gains like equity, but they do provide peace of mind and decent yield.
How to Invest Smartly in Low-Duration Funds
- Compare multiple funds and shortlist based on performance, credit quality, and fund manager experience.
- Use platforms like Value Research or Moneycontrol to review fund ratings.
- Avoid over-allocating. Use a part of your debt allocation for these funds.
- Always match the fund’s duration with your financial goal timeline.
- Monitor performance regularly and switch funds if needed.
By being mindful and strategic, you can make the most of low-duration mutual funds and beat the returns of traditional fixed deposits, especially when interest rates are expected to stay low or decline further.
