Medium Duration Mutual Funds

Debt Mutual Funds are those mutual funds which invest their assets in debt securities & money market instruments issued by corporates or governmental bodies. There are 16 different categories of debt mutual funds where each one has a different risk & return characteristic. Their suitability for investments depends upon the risk appetite, investment horizon & other requirements of the investors. One of the popular categories in debt mutual funds is Medium Duration Funds.

What are Medium Duration Funds?

Medium duration funds are those debt mutual funds that invest in debt & money market instruments with a Macaulay duration of the overall portfolio between 3 to 4 years. In layman’s terms, it means that these funds invest in securities with an average maturity of 3 to 4 years.

The higher modified duration than other debt categories with short maturities exposes these funds to higher interest rate risks. They are usually recommended to investors having a moderate risk appetite along with an investment horizon of 3-4 years. The return potential of medium-duration funds is higher than fixed deposits of the same tenure and therefore, is a very good replacement for fixed deposits.

Features of Medium Duration Funds

Portfolio

The fund manager of a medium duration fund forms a portfolio of debt securities in such a way that the Macaulay duration of the portfolio remains between 3-4 years. The portfolio could comprise of long as well as short term securities with different credit ratings as per the investment strategy of the scheme.

Returns

The returns from Medium duration funds are generally higher than that of the other debt schemes with shorter maturities such as short term, low duration, ultra short term, etc. As of October 2020, the Yield to Maturity (YTM) of medium duration funds is in the range of 6-8%. YTM is the expected returns from the fund if the underlying securities are held till maturity.

Risks

These schemes like all other debt funds do not guarantee any returns and are subject to risks. Some of the risks associated with medium duration funds include credit risks, liquidity risks & interest rate risks.

Credit risk is the risk associated with defaults on principal & coupon payments in underlying securities by the issuers which could further lead to capital losses for investors.

Liquidity Risk is the risk associated with liquidating the underlying securities by the scheme. The scheme might face issues in selling the securities due to low or no demand in the market. Or they might have to sell the securities at a discount to their value which can result in price cuts.

Interest Rate Risk is the risk associated with the volatility in returns owing to fluctuations of interest rates in the market. An increase in interest rates in the economy can lead to a fall in returns of medium duration funds over the short term because of their high modified durations and vice-a-versa.

Replacement to Fixed Deposits

Investors could consider medium duration funds over fixed deposits of tenures between 3-5 years. These funds have the potential to offer better than FD returns over the said horizon along with lower volatility.

Tax-efficient Returns

Gains realized while redeeming the units of medium duration funds for holdings over 3 years are taxable at a rate of 20% after indexation benefits. So, the effective tax rate comes out to be much lower especially for investors in higher tax brackets, and therefore, returns can be higher than fixed deposits with tenure of more than 3 years.

Important factors to consider before investing

Here are some important things you could consider before investing in medium duration funds:

Investment Horizon

It is important to state your investment horizon before making investments in any mutual fund. If you have an investment horizon of 3-4 years, then you can surely consider medium-term funds. Otherwise, you can opt for other categories in debt funds as per your requirements.

Risk Appetite

Investments in mutual funds should always be made as per your risk appetite so as to avoid experiencing any fluctuations in your portfolio returns which you can't handle. You can go for medium-term funds if you have a low to moderate risk appetite given it aligns with your investment tenure.

Expense Ratio

Expense ratio of the fund is the management & other administration fees which the AMC charges for managing the fund. The funds with lower expense ratios can be preferred as it will offer higher returns post expenses given that all other factors are favorable. However, the expense ratio should not be the deciding factor while investing in a mutual fund.

Fund's Portfolio

Investors should look for the quality of the portfolio i.e the credit ratings of its underlying securities. The funds with high-quality securities like SOV, AAA papers are considered to be very safe & therefore, the chances of defaults are lower. And the funds with a large proportion of their assets in low rated securities will have higher risks of default.

Yield to Maturity

The Yield to Maturity of a debt scheme is the expected returns it can generate if the underlying securities are held till maturity. So, the funds with higher YTM are expected to generate higher returns.

However, you must note that usually, the funds with underlying low rated securities will have a higher YTM to compensate for the higher risks taken. So, it's important to check the YTM & credit quality of the fund to align with your risk profile before making any investments.

Modified Duration

Modified duration is a measure of price sensitivity of the underlying value of securities in response to interest rate changes in the economy. The funds with higher modified durations are expected to have higher volatility in returns, due to its response to interest rate movements in the market. So, it's important to invest in funds which align with your risk capacity & investment requirements.

Taxation of Medium Duration Funds

Medium Duration Funds comes under the category of debt mutual funds and therefore has the taxability of debt funds. Following is the taxation applicable to gains earned on medium duration funds for different investment horizons:

If the units are sold within 3 years, then the gains on investments are treated as Short Term Capital Gains (STCG) and are taxed as per the income tax slab rate applicable to the investor.
If the units are sold after 3 years, then the gains on investments are treated as Long Term Capital Gains (LTCG) and are taxed at the rate of 20% after indexation benefits.

Investment Suitability- Who should invest?

Investments in Medium Duration Funds are suitable for investors having a low to moderate risk appetite with an investment horizon of at least 3-4 years. These funds can be a good pick over fixed deposits of the same time frame because of their potential higher & tax-efficient returns. Investors who hold these funds for more than 3 years can have the advantage of a lower effective tax rate i.e 20% after indexation benefits on the sale of holdings.

However, investors must note that these funds are exposed to the interest rate & default risks. Since these funds have higher modified durations of 3-4 years, they are significantly impacted by the interest rate movements in the economy. The default risks arise from the underlying low-rated holdings which might have been a part of the portfolio to generate higher returns for investors.

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