What are Debt Funds?
A debt fund is a type of mutual fund that invests in debt instruments such as corporate and government bonds, corporate debt securities, and money market instruments, among others. There are various types of debt mutual funds to accommodate investors with diverse risk-return profiles, time horizons, and financial objectives. Debt mutual funds invest in every type of debt, including treasury bills, government securities, commercial paper, certificates of deposit, money market instruments, securitized debt, and corporate bonds.
The primary distinction between debt and equity funds is that they invest in distinct asset classes. Equity mutual funds spend at least 65% of their assets on stocks and stock-linked instruments, whereas debt funds hold mostly bonds and cash assets. Keep in mind that the value of an investment is dependent on the values of the securities that comprise it. Given that bond prices are typically less volatile than stock prices, debt fund values are more stable than equity fund values. In other words, debt funds are deemed less volatile, particularly when held for brief durations.
What are Medium Duration Mutual Funds?
Debt funds are typically categorised based on their maturity. Low duration, short duration, medium duration, medium-to-long duration, and long duration are the categories of debt funds.
The Medium Duration Funds invest in debt securities with maturities between three and four years. This fund has a shorter maturity than short duration funds and a longer maturity than long duration funds. In other words, Medium Term funds are open-ended debt mutual funds that invest in securities with a Macaulay duration of around three to four years. In other words, medium-duration funds own securities with maturities of three to four years. These funds’ returns are approximately predictable. The rewards are not, however, guaranteed. There is credit risk interest rate risk, and liquidity risk involved.
These funds are vulnerable to interest rate risk since they have a longer duration than short-term funds. During the cycle of rising interest rates, bond prices decline. Due to their longer maturity than short-duration funds, they are the most affected. In addition, fund managers may invest in low-rated securities with the expectation that their credit ratings would rise over time. Consequently, these funds are also subject to default risk.
Medium duration debt funds are optimal for investors with a low to moderate risk tolerance. Those who wish to invest in medium- to long-term fixed deposits may also consider these. However, one must consider the associated dangers before investing in them.
Since medium-duation funds are a sub-category of debt funds, they are taxed similarly. Short-term capital gains (less than three years) are taxed at the individual’s rate of income tax. With indexation benefits, long-term capital gains are taxable at a rate of 20%. Those who fall under the highest income tax bracket can benefit from these investments if they remain invested for at least three years.
Features of Debt Mutual Funds:
- Returns: Medium duration debt fund returns historically have not fluctuate much. As these investments are in interest-bearing securities, one can anticipate a certain rate of return, although it is not guaranteed. If the portfolio manager has invested in assets with a low credit rating, the returns are vulnerable to credit risk.
- Risk: Despite the fact that debt mutual funds are considered low-risk investments compared to equity funds, they are not risk-free. Funds with a medium duration have long maturities, and the underlying securities can default on their payments. Therefore, they are highly susceptible to interest rate risk, credit risk, and liquidity risk.
- Volatility: Funds with a medium duration are particularly volatile in circumstances with fluctuating interest rates. A lowering interest rate regime increases the returns of these funds, whereas an increase in interest rates has the reverse effect. When interest rates rise, the returns on these funds fall. The greater the tenure of a fund’s holdings, the greater its volatility. The optimal investment horizon for medium-term funds is three to four years. This is due to the fact that their portfolio’s Macaulay length is between three and four years.
- Portfolio: A portfolio manager of a medium-term fund may invest in debt instruments with a maturity of around 3 to 4 years. The portfolio manager may invest in short-duration (including money market instruments) and long-duration debt securities with high to poor credit quality.
- Taxation: Medium-term funds are taxed similarly to debt funds. Short-term capital gains are subject to the investor’s marginal tax rate. The tax rate on long-term capital gains is 20%, with an indexation advantage. Those falling under the highest tax rate can benefit from investing in these funds.
How do Medium Duration Mutual Funds Work?
Debt Mutual funds invest in fixed-income securities. The issuing entity determines the fixed interest rate and duration of these instruments. Fixed-income securities also feature a credit rating that enables investors to assess the issuer’s default risk and select high-quality debt instruments. The better the rating, the lower the probability that the issuer would fail to return the principal investment amount and income received on your investment. Changes in the interest rate are also vulnerable to impact debt funds. Interest rate and bond price have an inverse relationship. Therefore, as interest rates rise, bond prices fall, and vice versa.
Who Should Invest in Medium-Duration Mutual Funds?
A medium duration plan is typically suitable for investors with a low to moderate risk tolerance. These funds returns are unaffected by equity market fluctuations and are somewhat predictable. The rewards are not, however, guaranteed.
Moreover, there is risk associated with these funds. The medium-duration fund is subject to significant interest rates and default risks. With a term of three to four years, these funds are susceptible to interest rate risk. In addition, the fund’s portfolio manager is free to invest in assets with varying credit ratings. Consequently, there is a possibility of default with these funds.
Factors to consider before investing in medium-duration mutual funds in India
Here are some crucial factors to consider before investing in India’s medium-duration funds:
- Risk
Medium-term funds are essentially debt funds. Consequently, these funds have the same three risks as all other debt funds: credit risk (or the risk of default by the issuer), interest rate risk (impact of rising or falling interest rates on the value of the fund), and liquidity risk (of the fund house). Therefore, it is essential to assess the fund’s portfolio to ensure that it invests in high-quality debt instruments with little credit risk. Also, investigate the performance of the fund manager during various interest rate regimes. A skilled fund manager can help you optimally withstand a period of rising interest rates. Nonetheless, these funds are less volatile than pure stock investing. Medium-term funds are also susceptible to specific hazards. These funds are affected by the fluctuating interest rate cycle due to the long maturities of their holdings. In addition, the fund manager may invest in low-rated assets with the hope that their ratings would improve. Therefore, the investment is susceptible to default risk.
- Expense ratio
In debt funds, where returns are already low, the expense ratio plays a significant influence. The expense ratio is a fee imposed by the mutual fund for fund management services and is expressed as a small proportion of the scheme’s total assets. The returns on debt mutual funds are lower than those on equity funds. In order to make big returns, it is essential to invest in funds with lower expenses. Each fund management company charges fees for their fund management competence. The expense ratio is the measure of cost. Investing in funds with a reduced expense ratio is advantageous. Funds also have an exit load. Exit load is the fee imposed by the fund house to discourage early withdrawals. Therefore, when investing, it is crucial to consider all fees and select funds with a low expense ratio and exit load.
- Investment strategy
Effectively achieving your financial objectives requires a well-thought-out investment strategy. This implies that you must have a clear definition of your investment objectives, risk tolerance, and desired investment duration. When investing, it is essential to keep in mind the duration of the investment. Every investment has a unique appropriate time horizon. Investing in stocks or shares, for instance, entails a lengthy investment horizon. Nonetheless, it is essential to be aware of the risks involved with these funds. If you have short-term or long-term objectives, you should seek plans that meet your needs sufficiently. Historically, Top 5 Medium term funds have historically provided returns between 7 and 9 per cent. However, past performance is not indicative of a guaranteed return.
- Credit rating
Investors are required to consider the credit ratings of the securities in which the medium-duration fund invests. This facilitates comprehension of the level of default risk. If the fund invests in an excessive number of low-rated securities, it has significant credit risk. Credit risk is the possibility that the issuer of a debt instrument will default at maturity. This risk is inherent to all debt funds. The fund’s underlying investments determine the degree or severity of the risk. If the fund has invested in low-rated debt instruments to achieve better returns, it is vulnerable to greater credit risk, and vice versa. To minimise credit risk, it is vital to examine the underlying investments of any fund before investing in it to ensure that the debt instruments are rated AAA or A+.
- Interest risk
Interest rate risk is the possibility that interest rates will fluctuate. Again, this risk is inherent to all debt funds, but the intensity of the risk varies with the duration of the fund. Compared to funds with medium to long maturities, funds with shorter durations have a lower interest rate risk. In the case of medium-duration funds, the risk of interest rate fluctuations is greater compared to liquid funds and funds with a short duration.
- Liquidity Risk
Liquidity concerns are the possibility that the fund will be unable to redeem the funds at maturity. To mitigate this risk, it is important to invest in regularly performing funds in this area and funds from reputable fund houses.
- Past Performance
Prior to making investment decisions, investors must also evaluate the performance history of the fund. This will allow them to comprehend the fund managers’ investing methods and determine if they align with the investors’ risk tolerance and investment objective. However, past performance is not indicative of guaranteed future returns.
Pros and Cons of Medium Duration Fund
- Taxation benefits: Comparatively, medium-term bond funds are more tax efficient than fixed deposits. However, the duration of the investment must be at least three years to get benefits under LTCG. In addition, investments in medium-term funds are eligible for indexation when the investment horizon exceeds three years.
- No guaranteed income: Medium-term funds, unlike fixed deposits, do not guarantee returns. Even while returns are somewhat predictable, a medium-term plan does not guarantee returns. Medium-term funds are vulnerable to risks such as credit risk, liquidity risk, and interest rate risk, among others.
- Risks: Medium-term funds are not entirely risk-free investments. These assets are susceptible to a number of hazards, including interest rate risk, credit risk, and liquidity risk. Changes in interest rates have a negative effect on bond prices. Since the period of these funds ranges from three to four years, interest rate risk is present.
The fund manager invests in low-rated assets with the idea that their ratings would improve. This puts the fund at risk of default. In addition, during periods of redemption pressure, it might be difficult for fund managers to quit their positions. This provides a liquidity risk to the investments.
Taxation on Medium Duration Fund
- Medium-term debt mutual funds are a type of debt fund. Consequently, these funds are taxed similarly to debt mutual funds. The gains from medium-term debt funds are taxable based on the holding duration of the investment. Gains on investments redeemed within three years are subject to Short-Term Capital Gains Tax (STCG). The gains are subject to tax at the individual’s income tax rate bracket.
- For redemptions after three years from the date of investment, however, the gains are subject to the Long-Term Capital Gains Tax (LTCG). The gains are subject to a 20% tax rate with indexation, or a 10% tax rate without indexation.
- In addition, an investor with the highest tax rate can benefit from these assets by holding them for at least three years.
List of Top Medium-Duration Fund in India (as per 3-Year return)
| Scheme | 3-Year Return | AUM (Cr) |
| Aditya Birla Sun Life Medium Term Fund | 10.10% | 1,615.13 |
| ICICI Prudential Medium Term Bond Fund | 7.81% | 6,322.48 |
| Axis Strategic Bond Fund | 7.48% | 1,681.17 |
| Tata Medium Term Fund | 7.44% | 74.91 |
| SBI Magnum Medium Duration Fund | 7.31% | 9,077.80 |
| HDFC Medium Term Debt Fund | 6.94% | 3,692.14 |
| Kotak Medium Term Fund | 6.89% | 1,905.98 |
| L & T Resurgent India Bond Fund | 6.84% | 690.34 |
| DSP Bond Fund | 5.71% | 341.45 |
| IDFC Bond Fund Medium Term Plan | 5.34% | 2,199.70 |
Source: AMFI (data as on 23/09/2022)
FAQs
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How risky are Medium Duration Funds?
Medium Duration Funds’ returns are vulnerable to the fluctuations in interest rates that borrowing companies experience as a result of positive or negative economic cycles. As a result, the returns on these funds can be unpredictable.
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Is there any exit load on Medium Duration Fund?
Most of the time, the exit load is based on the rules of the fund house. When units are redeemed, many fund houses may or may not charge an exit load. Typically, exit load is applied to units that are sold within a year of the initial investment.
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