Short-Term Debt Funds: A Smart Investment Strategy

Short-term debt funds are a type of mutual fund that provides stable returns and modest risk. They are suitable for low-risk investors with a low to moderate investment horizon of one to three years. These funds are highly liquid and provide tax benefits if held for over three years. When considering how to invest in short-term debt funds, it is important to look at the expense ratio, yield to maturity, and investment goals and horizon. Some of the best short-term debt funds in the market include UTI Short Term Income Fund, HDFC Short Term Debt Fund, and ICICI Prudential Short Term Fund.

Short-term investment options

• High-yield savings accounts: These accounts offer higher interest rates than traditional savings accounts, providing a good alternative for those seeking low-risk investments with higher yields. They are FDIC-insured, ensuring your money is protected.
• Cash management accounts: These accounts allow you to invest in a variety of short-term investments, often in safe, low-yield money market funds. They provide liquidity and the ability to access your money quickly, making them ideal for short-term goals.
• Money market accounts: Money market accounts typically offer higher interest rates than regular savings accounts, but they may require a higher minimum investment. They are FDIC-insured, providing protection for your funds up to $250,000.
• Short-term corporate bond funds: These funds invest in corporate bonds with maturities of less than five years. They are considered safe and pay interest at regular intervals. While they are not insured by the government, they offer diversification and lower interest rate risk.
• Short-term US government bond funds: These funds invest in government-issued bonds, such as T-bills, T-bonds, and T-notes. They are considered very safe due to the backing of the US government. These funds offer low interest-rate risk and reliable interest rates.
• Money market mutual funds: Money market mutual funds invest in short-term securities, including Treasury, municipal, corporate, and bank debt securities. While they are generally safe, they are not FDIC-backed, and there is a slight risk of losing money during severe market distress.
• No-penalty certificates of deposit (CDs): These CDs allow you to avoid the typical penalty for withdrawing your money before the maturity date. They are FDIC-insured and provide a higher interest rate than traditional savings accounts. However, there is a risk of missing out on better rates if you hold them for an extended period.
• Treasury bills (T-bills): T-bills are short-term US government securities with a maturity of up to one year. They are considered one of the safest investments and are highly liquid. However, this safety comes at the cost of lower yields compared to other options.
• Ultra-short-term mutual funds: These funds invest in debt securities and money market instruments with maturities between three and six months. They are ideal for conservative investors with a short investment horizon, typically up to six months. The average returns of these funds range between 7% and 9%.
• Debt mutual funds: Debt mutual funds lend your money to governments and companies, offering better post-tax returns than fixed deposits if held for at least three years. They are suitable for investors seeking regular income and those who want to park their short-term funds. Liquid debt funds are a great option for emergency funds, providing better returns than savings accounts with minimal risk.

How to choose a short-term debt fund

When choosing a short-term debt fund, there are several factors to consider. Here are some guidelines to help you make an informed decision:

Investment Goals and Horizon

It is essential to understand your investment goals and how long you are willing to invest. Short-term debt funds typically have an investment horizon of one to three years. If you need the money for a shorter period, consider ultra-short-term funds, which have an investment duration of up to six months. On the other hand, if you have a longer time horizon, you can explore medium or long-term funds.

Risk Tolerance

Short-term debt funds are generally considered low-risk investments. However, it is important to note that they are not entirely risk-free. Interest rate changes can impact the value of the fund, and there is always the possibility of capital losses if the investment is redeemed before maturity. If you have a low-risk tolerance, you may want to opt for even lower-risk options like fixed deposits or government bonds.

Expense Ratio

The expense ratio is the fee charged by the mutual fund on each unit of the scheme. It is essential to consider this fee when choosing a short-term debt fund, as it will impact your overall returns. Compare the expense ratios of different funds and choose one that aligns with your investment goals and budget.

Yield to Maturity

Yield to maturity helps investors calculate their expected returns over time. It is calculated by dividing the annualised interest rate by the number of days in a year. Compare the yield to maturity of different short-term debt funds to find the one that offers the most favourable returns for your investment horizon.

Credit Quality

Short-term debt funds invest in a range of debt instruments, including corporate bonds, government securities, and money market instruments. When choosing a fund, consider the credit quality of the underlying investments. Funds that invest in lower-rated debt may offer higher yields but also carry a higher risk of default. Weigh the potential returns against the level of risk you are comfortable with.

Fund Performance and Reputation

Consider the track record and performance of the fund you are considering. Look at the historical returns, volatility, and management style of the fund. Additionally, research the reputation and experience of the fund manager. Choosing a fund with a strong track record and a reputable fund manager can increase your confidence in the investment.

Taxation

Short-term debt funds may have different tax implications depending on your location and the length of your investment. In some cases, short-term capital gains may be taxed at your marginal tax rate, while long-term capital gains may be taxed at a lower rate with indexation benefits. Understand the tax rules applicable to short-term debt funds in your jurisdiction before investing.

Remember, past performance does not guarantee future results. It is essential to carefully consider your financial situation, risk tolerance, and investment goals before choosing a short-term debt fund. Conduct thorough research, consult a financial advisor if needed, and diversify your investments to minimise risk.

The benefits of short-term debt funds

Short-term debt funds are an attractive investment option for those with an investment horizon of at least a year, especially given the high volatility risk in the equities market. Here are some of the benefits of short-term debt funds:

Stability

Short-term debt funds are less sensitive to changes in interest rates compared to long-term debt instruments. This is because they have a shorter duration, typically between one and five years, which reduces the impact of interest rate fluctuations and provides stability.

Low Risk

Short-term debt funds are ideal for those new to the debt market or those with a low-risk appetite. They are considered lower-risk investments because they invest in high-quality debt instruments and money market assets, which have less credit risk. Additionally, the downward deviations are low in short-term debt funds due to the 3-year holding period, preserving capital.

Liquidity

Short-term debt funds offer good liquidity prospects as there is no lock-in period, and investors can withdraw funds anytime as per their needs, subject to tax implications and exit load. This makes them a good source of emergency funds.

Low Sensitivity to Inflation Risks

Short-term debt funds are mandated to follow the Macaulay Duration, which is the weighted average number of years for the present value of cash flows to equal the investment cost in a fixed-income instrument. This helps to reduce sensitivity to inflation risks.

Better Yield to Maturity (YTM)

Short-term debt funds can provide better YTM as they can earn from capital gains in addition to interest or dividend income.

Regular Income

Short-term debt funds are suitable for investors looking to earn regular income through investments. A Systematic Withdrawal Plan (SWP) facility allows investors to withdraw a pre-specified amount from mutual fund investments at regular intervals, making it a good option for senior citizens seeking regular income after retirement.

Alternative to Bank Savings

Short-term debt funds offer higher returns than fixed deposits at banks, with only a marginal increase in risk.

No Fixed Lock-in Period

There is no fixed lock-in period for short-term debt funds, and investors can withdraw their money at any time, making them a flexible investment option.

Risks of short-term debt funds

Short-term debt funds are not entirely risk-free. Here are some of the risks associated with short-term debt funds:

Interest Rate Risk

Interest rate risk is inherent in debt funds. This is because bond prices and interest rates have an inverse relationship. When interest rates rise, bond yields fall, and when interest rates fall, bond yields rise. This risk cannot be avoided in debt funds. The best way to manage it is by building an all-weather portfolio that includes both short-term and long-term investments, or by investing in dynamic bond funds that can benefit from both rising and falling interest rates.

Credit Risk

Credit risk, also known as default risk, occurs when the borrower is unable to repay the borrowed money. This risk is higher for debt funds that invest in low credit-rated securities. Conservative investors should invest in debt funds that focus on high credit-rated papers, such as corporate bond funds or gilt mutual funds, which carry zero credit risk.

Liquidity Risk

Liquidity risk arises when investors cannot easily sell their debt funds. This risk is higher for close-ended debt funds, such as Fixed Maturity Plans (FMPs), which can only be redeemed on a fixed maturity date and have very little liquidity. To avoid liquidity risk, investors should opt for open-ended debt funds, which can be redeemed at any time.

Reinvestment Risk

Reinvestment risk occurs when the underlying debt papers mature, and the fund manager has to reinvest in lower-interest-rate bonds due to a fall in interest rates. This risk can be mitigated by investing in long-term debt funds, which invest in long-term papers that do not mature frequently and, therefore, have lower reinvestment risk.

Concentration Risk

Concentration risk occurs when the debt fund manager fails to diversify the portfolio adequately. For example, if a fund manager invests a large proportion of the fund's corpus in a single company that subsequently goes bankrupt, the entire investment will be lost. Investors can avoid concentration risk by checking that the number of securities held by the debt fund is in line with its peers.

Market Risk

While ultra-short-term funds are generally considered low-risk, they are not entirely immune to market conditions. Economic downturns or financial crises can impact the performance of these funds, resulting in either returns or temporary losses.

Short-term debt funds vs other investment options

Short-term debt funds are a good option for investors who want to park their money for a short period, ranging from a couple of weeks to a few months. They are ideal for conservative investors with a low-risk tolerance and a short-term investment horizon. These funds typically invest in debt securities and money market instruments with maturities of up to six months. The average returns of these funds range between 7% and 9%.

When compared to other investment options, short-term debt funds offer a few advantages. Here's a comparison of short-term debt funds with some other popular investment options:

Short-Term Debt Funds vs. High-Yield Savings Accounts

High-yield savings accounts are a good option for risk-averse investors who want easy access to their money. These accounts are FDIC-insured and offer higher interest rates than regular savings accounts. They are highly liquid, allowing for quick transfers and withdrawals. However, investors may have trouble keeping up with inflation over the long term.

Short-term debt funds, on the other hand, can provide somewhat higher returns than regular savings accounts. They are also less risky due to the high credit quality of their underlying investments. While they are not insured like savings accounts, they are still relatively conservative investments.

Short-Term Debt Funds vs. Cash Management Accounts

Cash management accounts allow investors to put their money into various short-term investments, often low-yield money market funds. These accounts provide liquidity and flexibility, as investors can access their money quickly and perform typical banking activities. They are considered safe and are often FDIC-protected.

Short-term debt funds, while not as liquid as cash management accounts, offer the potential for higher returns. They are also less susceptible to interest rate changes due to their focus on short-term investments.

Short-Term Debt Funds vs. Money Market Accounts

Money market accounts are another type of bank deposit that typically offers higher interest rates than regular savings accounts. They are FDIC-insured and provide easy access to funds.

Short-term debt funds may provide similar or higher returns, depending on market conditions. They also have the advantage of being less sensitive to interest rate changes due to their focus on short-term investments.

Short-Term Debt Funds vs. Short-Term Corporate Bond Funds

Short-term corporate bond funds invest in bonds issued by major corporations. They are considered safe and pay interest at regular intervals. These funds provide diversification and are well-suited for investors who want exposure to a broad range of corporate bonds.

While short-term debt funds may offer slightly lower returns, they are generally considered less risky. They focus on high-quality, short-term investments, reducing the impact of interest rate changes.

Short-Term Debt Funds vs. Short-Term U.S. Government Bond Funds

Short-term U.S. government bond funds invest in government bonds, which are considered low-risk investments. They are backed by the full faith and credit of the U.S. government. These funds provide diversification and are highly liquid.

Short-term debt funds may offer similar or slightly higher returns. They also provide diversification and are less susceptible to interest rate changes due to their focus on short-term investments.

In summary, short-term debt funds offer a range of advantages when compared to other investment options. They are well-suited for conservative investors who want to park their money for a short period while potentially earning higher returns than traditional savings options. However, it is important to consider the specific features and risks of each investment option before making a decision.

Frequently asked questions