Medium Duration Debt Funds – Definition, Important Factors and Should You Invest in them
Last Updated : July 3, 2020, 6:18 p.m.
Debt funds invest in various debt securities such as corporate bonds, money market instruments, commercial paper, certificate of deposit, treasury bills and government securities. Different types of debt funds invest for varying maturities or duration of these securities. So, there could be a debt fund investing in securities maturing in a day, month, year, three years and more.
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Categories of debt funds are classified based on their maturity profile and the type of securities they buy in the portfolio. Medium duration funds are a type of debt fund. Let us understand more about these funds.
What are Medium Duration Debt Funds?
Medium duration funds are open-ended debt funds that invest in debt securities with a duration between three to four years. For simplicity, you can assume duration to be the time period in which the debt security will fully mature and return back all coupons or interest payments.
The objective of these funds is to deliver better returns than ultra-short, low duration and short term funds by taking a longer view on interest rate movements. Thus, these funds do have interest rate risk, which is higher than short-term and low duration funds.
These funds do well in a falling interest rate scenario and can outperform short-term and low duration funds by 1.50-3.00%. You can expect double-digit returns in a falling interest rate scenario. However, if interest rates move up sharply, these funds will underperform and you can expect single-digit returns
Like all other funds, these funds have their own benefits. Let us understand them.
Factors to Consider When Investing in Medium Duration Funds
Returns – These funds perform exceptionally well in a falling interest rate scenario. Returns can be as high as 10-12%, even beating returns from equity funds at times. However, one needs to be careful when investing in these funds since in a rising interest rate scenario these funds will not do well, and returns could reverse.
Volatility – These funds are more volatile than short-term or low duration funds. Sharp movement in interest rates will lead to a sudden change in NAVs.
Risk – These funds carry both interest rate and credit risk. A sudden or expected rise in interest rates can lead to negative returns also on some days. Medium duration funds are certainly riskier than low duration, short term and liquid funds.
Time Horizon – When investing in medium duration funds, you should invest with a time horizon of at least 3-4 years since these funds carry a similar duration and should deliver expected returns in this period.
Taxation – A time horizon of three years also makes these funds more tax efficient since you can avail of the indexation benefit. Post indexation, the tax liability works out to NIL or very low.
Should You Invest in Medium Duration Funds?
Medium duration funds are suitable for people who are looking to invest with a time horizon of 3-4 years and are aiming for higher returns with a higher risk than low duration or short term funds. If you want your debt investment to be completely risk-free, you are better off investing in overnight or liquid funds only.
However, if you are looking for that extra 4-5% over liquid funds with a higher risk, you can invest in medium duration funds. These funds qualify for debt fund taxation. Please note that if you withdraw before a year from a debt fund, STCG (short term capital gain tax) is applicable which is basis a person’s tax slab.
So, you should calculate the post-tax return before investing. If you invest in a medium duration fund that gives you a 9% return and if you are in the 20% tax bracket, the net returns post-tax will be 7.20%. This return is higher than savings bank accounts, fixed deposits and liquid funds.
We recommend investing in medium duration funds only if your time horizon is 3-4 years. These funds can be a replacement for a 3-4 year fixed deposit, but you need to keep in mind that unlike a fixed deposit these are not risk-free.
In the current scenario, interest rates have already fallen significantly and might not fall as much like the past two years. It is advisable to have a time horizon of 6 months to 18 months currently for investing duration based debt funds.
So, if you are looking to invest for a time horizon of 6 months to a year, we would advise you to invest in low duration funds. To know about low duration funds you can read another post of ours – Low duration funds-definition, benefits and should you invest ?
If your time horizon is between a year to 18 months, it is ideal to invest in short-term debt funds. To know more about short-term debt funds and the best short-term debt funds to invest in, you can read another post of ours- https://www.wishfin.com/mutual-fund/three-best-short-duration-funds-to-invest-in/