Short Duration Debt Fund

Short-term debt funds refer to mutual funds suitable for low-risk investors with a low to moderate horizon of one to three years. Read continue.
EXPLORE FUNDS
Short Duration Debt Fund
EXPLORE FUNDS
3 min
07-December-2024

A short duration debt fund, also called a short-term debt fund, invests in money market instruments and debt like government securities, commercial papers, treasury bills, and deposit certificates. On SEBI mandates, these funds are not only for the short term but open-ended also. Moreover, a short duration debt fund has the Macaulay Duration, which, simply put, is the weighted average of the number of years in which the present cash flow values equals the cost of investment in a fixed-income instrument for a period of one to three years.

For how long does a short duration debt fund operate?

The fund’s duration is dependent on its underlying securities’ maturity. Duration is also a gauge of the impact on the fund’s value and is based on interest rate fluctuations in the market. If the duration is high, so will the volatility arising from rapidly fluctuating interest rates in the market. Hence, the interest rate risk will also be higher.

Objectives of a short duration debt fund

The fundamental target of a short duration debt fund is investing in secured instruments that are hardly influenced by fluctuating interest rates in the market. Hence, such funds are less affected by changes in interest rates. Moreover, such funds are relatively more stable than long-term debt funds, give higher returns than the Ultra-Short Duration Funds and are quite liquid also.

Benefits of Short Duration Debt Funds

Preferred by Newcomers

Newcomers to the debt market find short-term debt funds ideal since they are usually risk-averse but look forward to decent returns on their investments and also easy liquidity.

Stable Returns

A short duration debt fund gives out more stable returns over short durations owing to interest rate cycles easing and tightening, compared to fixed deposits, Short-term Mutual Funds, or Ultra-Short Duration Funds.

Lower risks

In any adverse market condition, the risk factor is lower since deviations downward are lower, which helps preserve the capital in the long run. However, it may be said that no short duration debt fund is absolutely risk-free.

Higher liquidity

Since short duration debt funds have no lock-in period, they can be sold anytime, particularly during financial emergencies, subject to exit load and tax implications, if any.

The other notable benefits are as follows:

  • Less affected by inflation-related risks since SEBI has mandated following the Macaulay Duration principle.
  • A good investment for earning capital in times of lower interest rates since the value of the fund increases on the spiralling prices of its underlying investments.
  • Higher Yield to Maturity (YTM) since a short duration debt fund also earns from capital gains besides interest/dividend income.
  • Lower risk of default as against credit risk funds since these are mostly investment-grade securities. Any equity investment lower than 65% is not termed equity but a debt fund.
  • There is no lock-in period since these are unregulated broadly and depend on the investment pattern of the fund manager along with the current portfolio allocation of the investor.

Taxation of Short Duration Debt Funds

Debt funds, including short-duration funds, primarily consist of debt securities and are categorized as 'other than equity-oriented funds' for tax purposes. The tax implications for these funds depend on the duration of the investment.

Short-Term Capital Gains (STCG)

  • If the investment is held for less than 36 months, any gains are considered STCG.
  • These gains are added to the investor's taxable income and are taxed at the applicable regular tax rates.

Long-Term Capital Gains (LTCG)

  • If the units are held for 36 months or more, the gains are classified as LTCG.
  • LTCG are taxed at a rate of 20% (plus applicable surcharge and Cess).
  • Investors can benefit from indexation, which adjusts the invested amount for inflation based on the Cost Inflation Index (CII) notified by the government. This adjustment effectively lowers the tax rate on LTCG for these funds.

Conclusion

Short Duration Debt Funds offer a compelling investment option for those seeking to balance returns with risk management. By investing in debt and money market instruments with a Macaulay duration between one to three years, these funds provide a moderate level of interest rate risk while potentially offering better accrual income compared to other short-term instruments. The careful management of credit risk and the relatively straightforward investment process make these funds accessible and appealing to a wide range of investors.

Moreover, understanding the tax implications is crucial for making informed investment decisions. Short Duration Debt Funds are taxed based on the holding period, with Short-Term Capital Gains (STCG) being taxed at regular income tax rates for investments held less than 36 months, and Long-Term Capital Gains (LTCG) benefiting from a lower effective tax rate due to the indexation benefit for investments held 36 months or more.

In summary, Short Duration Debt Funds can be a suitable choice for investors looking for a blend of stability, manageable risk, and potential for moderate returns, making them an attractive component of a diversified investment portfolio.

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Frequently asked questions

Are short-term debt funds safe?
Short-term debt funds are relatively safer options for those investors who seek capital preservation and income, particularly in comparison with longer-term bond or equity funds. However, any investor needs to assess all risks associated with such funds carefully, while also considering other factors like sensitivity to interest rate, credit quality, regulatory environment, and liquidity before investing.

What is short-term debt funding?
Short-term debt funding is raising or borrowing capital for a short time period, which is usually under one year, to fund short-term projects or for meeting immediate financial needs. This kind of funding is used commonly by governments, businesses, and individuals to tackle temporary cash shortages, take care of immediate requirements for working capital, or to take advantage of any opportunity that requires fast access to funds.

What is the difference between FD and short-term debt funds?
Fixed Deposits (FDs) and short-term debt funds differ in terms of their nature of investment; varying returns for short term debt funds, while FDs have fixed rates of return; short term debt funds have a higher risk; short term funds also have a higher liquidity than FDs based on its NAV; Fixed Deposits are low-risk since the government insures them through several insurance schemes, whereas short-term debt funds are slightly more risky due to interest rate fluctuations, credit risks that come with underlying securities, as also market volatility. However, they are still considered relatively low-risk investments compared to equities or long-term debt funds. Also, interest on FDs is taxable on the income tax slab rate of the investor, whereas returns from a short-term debt fund are treated as capital gains.

Is debt fund better than FD?
Whether a fixed deposit is better or a debt fund can only be decided based on the investor’s objectives, time horizon, and risk appetite. For those who prefer fixed returns and safety, a fixed deposit can be suitable. Conversely, for those seeking higher returns but with some flexibility and risk, a debt fund is a better choice.

Why should you invest in short-term mutual funds?
A short-term mutual fund is a viable investment option due to its higher stability, liquidity, assured regular income, diversification, accessibility, and capital preservation.

Do short-term funds have an exit load?
Depending on its investment objectives, a short term fund may or may not have an exit load.

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