Long Duration Debt Funds: Meaning, Type, Risk, Returns, Benefits, Taxability

About Long Duration Debt Funds

Due to lower risk compared to equity, moderate returns, and effective tax treatment due to indexation benefits, long-term debt funds are a good investment option to consider. Investors with a longer investment period prefer these funds. People with a low-risk appetite should try and stay away from long-term debt funds because they are more risky compared to short-term debt.

Types of Long Duration Debt Funds

Some long-duration debt funds are as follows-

1. Income Funds

By investing in government securities, certificates of deposits, corporate bonds, money market instruments, and debentures, income funds predominantly focus on generating daily income for investors. These funds are super vulnerable in terms of interest rates through market changes. Income funds, however, seek to produce returns by effectively monitoring the portfolio, even when the market is unpredictable and interest rates are not steady.

2. Gilt Funds

Gilt Funds are debt funds that invest only in bonds issued by the state and central governments and are fixed interest-bearing securities. These investments are made in instruments with maturities that vary. These funds are said to carry minimal default risk since the money is invested with the government. The low credit risk is also because, by issuing debt securities, the government seldom defaults on the loans it receives from the public. This makes these funds perfect for fixed-income investors who are risk-averse. However, since the underlying holdings are long-duration bonds, the funds do carry a high-interest rate risk.

3. Dynamic Bond Funds

These funds consist, as the name implies, of a portfolio which is complex in terms of composition and maturity. As per the evolving interest rate system, fund managers continue to adjust the composition of the portfolio. Typically, these funds have a large amount of assets under control with a multiple thousand crore value. For investors who are not specialized in making the right decisions depending on the interest rate movement, dynamic bond funds are suitable.

Who should invest in Long Duration Debt Funds?

Fairly conservative in nature, for the sake of stability, debt funds can be a perfect partner for an equity-oriented portfolio that is focussed for long term (5 years or more) investing. By investing in debt funds, conservative investors who expect to remain invested for about 5 years will build their money. For those who want highly liquid avenues to park their short-term funds can go for liquid funds. A part of their portfolio may be assigned to debt funds by long-term investors that fall in the higher tax bracket. Since the long-term capital gains on redemption earn the advantage of indexation and are taxed at the rate of 20 percent, it can lower their tax liability. Also, since the tax in case of mutual funds is only payable at the time of redemption, the tax is deferred to a much later date.

How to select Long Duration Debt Funds?

The suitability of debt funds depends more or less on the individual's risk aversion. Gilt funds, for instance, are less risky than other debt funds in terms of credit risk.

When interest rates decline, long-term funds provide buyers with the best prospects.

The following points for assessing long-term debt funds should be considered by investors:

Fund Record: Always consider a fund house in the investing sector that has a long and reliable experience of consistent market success. To pick the best debt fund, acknowledge the track record of the last 5-10 years.

Returns of the Fund: An investor would look for consistent returns over a long-term span of 3-10 years say. Then choose funds that have outperformed their peer funds and managed to cross the benchmark rate of return across different time frames.

Before investing in a debt fund, you can describe your objectives, risk profile, and investment horizon as well. For long term investors, long-duration funds may facilitate the wealth creation purpose.

Taxation of Long Duration Debt Funds

Bond funds are taxed differently from equity funds. If debt funds are kept for more than 3 years (long-duration capital gain tax), 20% is charged with the benefit of indexation. On the other hand, if the units are redeemed within a period of 3 years, the gains are considered as Short Term Capital Gains (STCG). STCG is taxed as per the income tax slab of the investor. For investors falling in the highest tax slab, a rate of 30% (plus surcharges) will be applicable.

Long Duration Debt Funds Risks

Long duration debt funds carry 2 primary risks - default or credit risk and interest rate risk.

Default Risk - Default risk or credit risk refers to the risk that the issuer of a debt instrument will default on the payment of the interest or principal amount. Gilt funds normally do not carry this risk since the issuer is the Government. However, bonds investing in corporate deposits or bonds of companies do carry this risk.

Interest Rate Risk - The prices of bonds are inversely related to the movement in the interest rates in the economy. If interest rates go up, the price of bonds falls and vice-versa. The extent of the effect is directly related to the time to maturity of the bond, measured by Modified Duration. Hence, the interest rate risk is much higher in longer duration debt funds than in shorter duration funds.

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