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Short Term Debt Funds

What are short-term debt funds?

A short-term debt fund refers to a mutual fund scheme for investments spanning about one to three years, though it may extend to four years as well. This investment is usually accompanied by stable returns and modest risks. Short-term debt funds are often equated to bank Fixed Deposits (FDs) of equivalent tenures at the time of investing due to similar investment terms.

However, a short-term debt fund proves to be more tax-efficient over three years as compared to a FD. Despite it being comparatively riskier than an FD, experts generally recommend it over its competitor from the perspective of liquidity, returns and taxation. Investing in debt funds has attracted an annual return of more than 10% as opposed to FDs recording a rate card of a maximum 7%, as witnessed in the last few years.

Short-term funds do not attract penalty on their redemption before the maturity date, unless they are redeemed before the pre-determined period. Usually this term varies between five days to six months. In contrast, FDs despite being high on liquidity, attract a penalty of up to 1% on being redeemed before its date of maturity.

The recent rules for the mutual fund industry has introduced a control over high duration scrips, which was once the usual norm for short-term debt funds. Restricting the duration scrips between one to three years has brought the volatility under control, protecting it from undue risks. Short-term debt funds no longer face exceptionally high interest rate risks, though some of them can be exposed to credit risks.

Benefits of Short Term Debt Mutual Funds

Let's discuss the factors that make short-term debt funds a smart investment option.

Enjoy stable returns

Debt funds are generally classified under the categories of Liquid Funds, Floating Rate Funds, Corporate Bond Funds and Ultra Short Term Funds. This classification is done basis the holding period of the investment. This is applicable in the case of varied debt instruments and fixed income securities such as Government Securities, Treasury Bills, Corporate Bonds and Money Market Instruments, etc. Resultantly, the tax implications differ depending upon the category of fund.

Debt funds are preferred over equity funds as the investment towards fixed income securities and debt instruments usually offer a fixed rate of return and have a pre-determined date of maturity. What’s more, they are not affected by the capital market movement.

Maintain a Balanced Portfolio

Short-term debt funds play an integral role in the asset allocation strategy. They score over equity investments as they are able to avert risks caused due to capital erosion during the short-term of below 3 years. Therefore, equity fund investment for liquidity or as a means for achieving short-term financial goals is not a recommendable option.

Meet Financial Goals

Short-term debt fund investments work as a suitable means for meeting financial goals varying between one to three years, and even lesser than a year. This is because they hold a record of offering greater post-tax returns as compared to other non-equity counterparts of the same tenure. Not just that, even ultra-short-term funds guarantee high gains because of the lack of penalties on pre-mature redemption, which is applicable on equity funds. This also imparts greater immunity from interest rate movements arising due to lower average maturity period.

However, short-term debt fund, contrary to what is suggested by the name, can be considered for long-term investments as well. In fact, it proves to be a smart investment when held for more than 3 years as well, outperforming FDs yet again. While interest received from Fixed Deposits is taxable as per the income tax slab that is applicable to your income bracket, the tax treatment of returns realised from short-term funds depends on the holding period.

Gains realised within three years of investment are taken as short-term capital gains and considered to be a part of your income during tax computation. Gains realised after 3 years are taken as long-term capital gains tax and taxable at 20% with indexation and 10% devoid of indexation. For instance, short-term debt funds like Kotak Flexi Debt – Plan A has ensured returns of up to 9.48% in one year, while Kotak Banking & PSU has given a return as high as 10.13% in three years.

Risks in Investing Short Term Debt Fund

Though short-term debt funds carry low risk exposure as compared to equity funds, they are not devoid of risks. You need to be aware of the possible risks, so you can take a well-informed decision that will meet your financial goals.

Here are the possible risks of short-term debt funds:

Exposure to Credit Risk

You will be vulnerable to credit risk when you default on payments. Short-term debt mutual funds have varied credit risks and the ratings awarded to each one of them by credit rating agencies like CRISIL indicate their risk exposure and quality of portfolio investment. For instance, a high rating given to a short-term debt mutual fund of a certain bank or financial institution refers to its low risk. Government securities usually have a high credit rating that corporate debt funds. A higher rating also results in a price drop.

The corpus is invested in a diversified portfolio of securities by short-term mutual funds. Therefore, you need to research well and check on these factors before arriving at a decision, so you have a stable portfolio.

Fluctuating Interest Rate

The return on a short-term debt mutual fund is determined by the prevailing interest rate. A higher interest rate will have an adverse impact on your returns as it will cut into your gains. A lower interest rate will have an opposite impact on your returns.

The fluctuations in interest rates also have an impact on the prices of mutual funds, and hence its value. A rise in the interest rate of a short-term mutual fund will bring down its price, and vice versa. When the interest rate increases, leading to a reduction in the price of short-term mutual funds, it also results in the fall of its value. On the other hand, a fall in the interest rate of a short-term mutual fund raises its price and, simultaneously, its value also increases.

The above determining factors make it essential for you to analyse the existing interest rate of a short-term mutual fund before including the same in your portfolio. Your Fund Manager can adjust the allocations by assessing and foreseeing the future economic scenarios, which in turn will impact the interest rates. However, predictions are not always averse to risks. A misjudged situation may result in the opposite of what you had anticipated.

Risks Arising from Low Maturity Period

Check the average maturity value of the portfolio to have a clear idea of the interest rate risk. The lesser the time for the fund to reach its date of maturity, the lower will be the impact of the change in interest rate.

Inflation Risk

Inflation may negatively impact short-term debt mutual funds in two ways. It may lead to a steep rise in interest rates, bringing down the value of debt mutual fund investments. A higher inflation rate may adversely affect the return on your investment.

Liquidity Risk

The flexibility to opt and exit from a short-term debt fund varies. Opt for one that allows you the kind of flexibility that will suit your unique needs. Apart from this, also consider the changing interest rate environment before select a debt fund that meets your investment goals.

Top 10 Short Term Debt Mutual Funds

The below illustration will give you an insight into the top 10 short-term debt funds that you can invest in in the first quarter of 2018.

Top 10 Short-term Debt FundsCRISIL RankRiskCurrent Status
HDFC Short Term Debt Fund (G)
Rank 1
Moderately low
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one
IDFC Bond Fund - MTP (G)
Rank 1
Moderately
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one
L&T; Short Term Bond Fund (G)
Rank 1
Moderately low
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one
Kotak Corporate Bond Fund - D (G)
Rank 1
Moderately low
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one
HDFC Short Term Debt Fund (G)
Rank 1
Moderately
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one
HDFC Short Term Debt Fund - D (G)
Rank 1
Moderately low
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one
IDFC Bond Fund - MTP - D (G)
Rank 1
Moderately
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one
L & T Short Term Bond Fund - D (G)
Rank 1
Moderately low
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one
IDFC Bond Fund - STP - Direct (G)
Rank 2
Moderately low
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one
Kotak Dynamic Bond Fund (G)
Rank 2
Moderately low
  • Good performance
  • Unchanged rank since the last quarter
  • You may stay invested, if you have already invested in one

FAQs on Short Term Debt Funds

Are short-term debt mutual funds suitable for longer investment tenures?

Yes, short term debt mutual funds are usually meant for investors looking for a short-term investment tenure of 1 to 3 years. It may be retained for a longer period if they fetch good returns.

Why are short term debt mutual funds good investment options now?

Short term debt mutual funds are the best investment options in an unpredictable interest rate environment. They usually perform well when interest rates are high and are expected to drop as a result of accruing high yields to maturity and increase in price. However, it also can fair well when interest rates are low. A rising interest rate may lead to a price drop, which in turn may cause a fall in the value of the debt fund. Further, the fluctuations in interest rate do not affect the returns on short-term debt funds as much as it does for long-term debt funds.

Not just that, a short-term debt mutual fund is considered to be a better investment option than commercial papers and short-term bonds, especially in uncertain economic times like the one we are in now. As a result, short-term debt funds have the recommended option from financial experts in over last six months.

What is the difference between debt and liquid fund?

Though liquid fund is a type of debt fund, there is a distinct difference between them from the perspective of risk factor, purpose, risk and return expectation. Liquid Fund invests in money market instruments that are highly liquid like Certificates of Deposit (CDs) or Commercial Papers (CPs) but does not offer high returns. It is equivalent to an emergency fund or money in your savings account. However, contrary to popular opinion, it should not be confused with cash in your savings account that can be withdrawn in an instant. It takes one or two days to get cash from liquid funds. The period of investment is as short as a maximum of 91 days.

Debt Fund, on the other hand, has no restrictions on debt instruments that can be invested in. The holding period usually vary between 1 to 3 years. It is a much-recommended investment plan due to its liquidity, taxation and the returns that it offers. It is a safe investment option with moderate risks.

What is difference between equity and debt funds?

A debt fund is a mutual fund investment that invests in securitized products, short-term/ long-term bonds, floating rate debt or money market instruments. In contrast, equity funds or stock funds is also a type of mutual fund investment, but here money belonging to shareholders are invested in stocks.

What is debt fund with example?

A short-term debt fund refers to a mutual fund scheme for investments that usually spans between one to three years. This investment is usually accompanied by stable returns and modest risks. For instance, Kotak Banking & PSU has given a return as high as 10.13%.

What is liquid plan mutual fund?

Liquid fund is a classification of mutual fund investments that usually invests in money market instruments like Certificate of Deposits (CDs), Commercial Papers (CPs), Treasury Bills and term deposits. It is equivalent to an emergency fund or money in your savings account. However, contrary to popular opinion, it should not be confused with cash in your savings account that can be withdrawn in an instant. It takes one or two days to get cash from liquid funds. The period of investment is as short as a maximum of 91 days.

What is debt in mutual fund?

Debt Mutual Fund investments are a blend of debt or fixed income securities like Government Securities, Treasury Bills, Corporate Bonds, Money Market instruments, etc. Debt Funds usually have a fixed date of maturity and pay on the basis of a pre-determined rate of interest. The returns comprise of the income from interest, and capital appreciation or depreciation determined by changes in market movement.

They are awarded ratings by independent credit ratings organisations like CRISIL as is an evaluation of the credit worthiness of the issuers of fixed income securities, that is, banks and financial institutions.

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