In this article we will look at one type of debt mutual fund, based on its duration – Medium Duration Mutual Funds.
We will understand what these funds are, the fund characteristics, as well as their advantages and disadvantages.
About Medium Duration Mutual Fund
A medium duration mutual fund is a type of debt mutual fund. It is classified based on its duration.
Duration of a mutual fund is the period till maturity of the debt securities comprised within its portfolio.
Essentially it means the time frame within which the held debt securities would get redeemed with payback of the entire principal as well as its accrued interest.
A medium duration mutual fund invests in debt securities in such way that would keep the Macaulay duration of its portfolio between 3 to 4 years.
The Securities Exchange Board of India (SEBI) has laid out this criterion in its published guidelines.
Macaulay duration is ascertained by calculating the weighted average of the present value of cash flows of the mutual fund.
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Features of Medium Duration Mutual Funds
Here are few important features of Medium Term Mutual Funds –
Composition of Fund Portfolio
Being a debt mutual fund, medium duration fund invests in different types of debt securities. These can be government bonds, corporate bonds, commercial paper etc.
The fund manager of such funds generally invest in a mix of high rated and lower rated bonds (AA and below).
The rationale behind investing in lower rated bonds as well is to maximize potential returns from the fund.
Lower rated bonds will typically carry a higher coupon rate as it carries a higher risk as well. This high coupon rate can help increase the overall return of the fund.
Risk Factors in Medium Duration Mutual Funds
Medium duration funds are subject to the risks that debt mutual funds are subject to – namely interest risk, credit risk and liquidity risk.
Interest risk is the risk that value of bonds can fall in response to interest rate increase.
Since the duration of these funds are longer – 3 to 4 years they can be susceptible to interest risk through this duration.
As the fund also invests in a certain quantum of lower rated bonds it also exposes itself to credit risk arising from default in payment of principal and/or interest by the bonds.
The duration of 3 to 4 years further accentuates this risk. These funds are however not subject to market risk such as is the case with equity and hybrid funds.
Thus, medium duration funds have higher risk than liquid funds, overnight funds and short-term duration funds.
They however do have considerably lower risk than equity and hybrid funds.
Return Potential of Medium Term Mutual Funds
The medium duration funds earn stable returns. They can be fairly predicted based on the debt securities’ coupon rate. Fund managers may invest partially in lower rated bonds.
Thus, they can earn better returns than traditional saving instruments such as fixed deposits.
A good fund manager can also arise from change in market interest rates to maximize the value of its portfolio.
Medium duration mutual funds can thus earn higher returns than overnight, liquid funds or short duration mutual funds but lower returns than other classes of mutual funds such as equity or hybrid mutual funds.
The taxation of medium duration mutual funds is akin to that of debt mutual funds. It is taxed only on redemption.
The gain arising from redemption is taxed as capital gains – short term in case the fund is held for less than 3 years and long term in case it is held for more than 3 years.
As the ideal duration of these funds is 3 to 4 years, investors can also reap benefits of indexation benefit in case of long-term capital gains.
Short term capital gains on redemption are taxed at the slab rate applicable to the investor.
Long term capital gains are taxed at a beneficial interest rate of 20%. There are no TDS implications.
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Who should Invest in Medium Duration Funds?
The specific characteristics of medium duration mutual funds make them suitable for certain type of investors. These include:
Investors having Medium Term Goals
Medium duration mutual funds have an ideal investment horizon of 3 to 4 years.
This makes them suitable for investors who are looking to invest money to fund their medium-term goals of 3 to 4 years.
Timeline of more than 3 Years
Investors should ideally keep a timeline of more than 3 years while investing in these funds. For shorter time frames up to a year they can choose low duration mutual funds instead.
Moderate Risk Appetite
These funds are suitable for investors seeking better returns than traditional saving instruments such as savings accounts and bank fixed deposits as well as of low duration funds.
If investors have a moderate risk appetite, they can invest in these funds to earn a better return.
Evaluation of Medium Term Mutual Funds
Before you decide to invest in medium duration funds, you should evaluate certain factors. These include:
These funds are subject to interest risk, credit risk and liquidity risk. Hence investors must appropriately evaluate these risks.
Investors can assess the quality and ratings of debt securities within the fund’s portfolio. This is of utmost importance as it impacts the risk of default that an investor bears.
Investors should also analyze the expertise of the fund manager through different interest cycles.
Fund managers who have succeeded in maximizing the value of the portfolio through falling interest periods as well as those who safeguard the value of the fund through increasing interest periods should be chosen.
All fund houses charge a fee for managing the issued mutual funds. This fee is calculated as a % of the total assets under its management. It is called ‘expense ratio’.
The lower the expense ratio of the fund the better the returns earned from it. Thus, investors should also assess funds on the basis of their expense ratio.
Suitability to objectives
Medium duration mutual funds suit investors who have an investing time frame of 3 to 4 years.
Thus, an investor should confirm the time frame of the objectives which he is looking to fund through investment in these funds.
In case he is looking to fund shorter duration goals, other funds such as liquid funds or short duration funds should be preferred.
This is because risk absorption will be poorer for medium duration funds if opted for a shorter time period.
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Benefits of Investing in Medium Duration Mutual Funds
Here are some of the most important benefits of Medium Term Mutual Funds –
Medium duration mutual funds can earn higher returns when compared to traditional saving instruments such as fixed deposits.
They can also earn better returns than other debt mutual funds such as liquid funds or short-term duration mutual funds.
These funds are more tax efficient than fixed deposits. This is because they are taxed only on redemption and not periodically as is the case with fixed deposits. They are also not subject to any TDS.
Medium duration funds held for more than 3 years will also get the benefit of indexation when taxed on redemption. This can further reduce tax liability of investors.
Drawbacks of Medium Duration Funds
Here are list of major drawbacks of Medium Duration Mutual Funds –
Interest rate risk accentuated due to a longer duration
Investors ideally hold medium duration funds for 3 to 4 years. This makes them more susceptible to interest rate risk.
Interest risk is the risk of changes in valuation of the portfolio due to changes in market interest rates.
When market interest rates rise, the portfolio holding lower coupon rate securities will lose value.
This is because the debt securities offering lower coupon rates than market rates will become less attractive and thus their prices will fall.
Credit risk on account of relatively low rated investments
As these funds invest a proportion of their portfolio in lower rated bonds, they run a credit risk. A longer duration of 3 to 4 years can enhance this risk of default.
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Medium Duration Mutual Funds – Conclusion
Medium duration mutual funds are thus suitable for you if you have a medium-term investing horizon and are looking for better returns in exchange for a moderate risk appetite.
Mid-term investment goals such as kids’ education, upgrading your car or renovating your home can be funded through investment in medium duration mutual funds.
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