June 07 , 2012
What is a short-term debt fund?
A short term or short duration debt fund (also called income fund) is a mutual fund that invests in debt instruments with short maturity or duration (usually less than three years). Banks, companies and the Government often borrow from the market for these duration, and issue paper in return. These funds invest in such paper.
Since the tenure / duration tends to be short, the value of these funds is not affected much by changes in interest rate. On the other hand, these are affected in case some of these companies or banks default. This risk is called credit risk. While it is much smaller than the risk in equity, it is still something to remember.
Advantages of a short-term debt fund
The biggest advantage of a short term debt fund is that it is not affected much by interest rates. This makes its returns more stable and safe.
A short term debt fund scores over fixed deposits in its flexibility. A fixed deposit has a penalty for early breakage - his can be deterrent if you do not know when exactly you will need the money. Most short term debt funds, on the other hand allow free exit at any point of time.
If you are investing for over a year, and if you fall in a high tax bracket, a short term debt fund is also more tax efficient than a fixed deposit. Gains in a short term debt fund are then taxed at just 10%. In contrast, the interest on fixed deposits would be taxed at your highest rate - 30% or 20% as the case may be.
Limitations of a short term debt fund
Debt of any form works best if you need the money in 2-3 years' time. If you are parking money for longer, you had better look at equity. Otherwise, inflation will eat away any returns that you may get. A short term debt fund is no exception.
The other risk in a short term debt fund is the small risk that some of its borrowing companies may default, and lead to a loss. However, this risk is typically very minor. Except during times of economic recession, you can invest in short-term debt funds without this fear. Even during the downturn of 2008-09, almost no short-term debt funds lost money.
Is a short-term debt fund for me?
Do you need some money in the next 2-3 years, but are unsure when exactly it will be required? Then short-term debt funds are the best option for you. They give much better returns than bank savings accounts, are more flexible than fixed deposits and less risky than equities.
Some examples include:
- A plan to buy a house in 2-3 years time (which will need down-payment money)
- Daughter's wedding that is likely to come up in a couple of years
For longer term requirements and general wealth building, debt is a bad idea. You would do well to look at equity funds.
How do I choose my short term debt fund?
Even if you are not used to analysing mutual funds, you are unlikely to go very wrong with short-term debt funds. Choose one of the reputed fund houses (HDFC, Birla, ICICI Prudential, Reliance or Franklin) and pick one of their short-term debt funds. The information is given in their application form booklets itself.
If you want to do more research, you can look at the fund's portfolio. Avoid ones that have too many real estate companies in their portfolio. Funds having banks or Government paper on their portfolio are safest, and usually the best for you.