What is Short-Term Debt Fund: Meaning of Short Term Fund, Benefits, Taxes & How to Invest

Short-term Duration Funds are an attractive avenue for investment in an investment horizon of at least a year, given the high volatility risk in the equities market. This blog post takes account of different aspects related to the Short Duration Fund, its advantages, taxation implications and more.

Short-term Mutual Funds Meaning

Short-term Mutual Funds definition: A short-duration fund, aka Short-term Debt Fund, is a type of fund that invests in debt and money market instruments such as commercial papers, government securities/ treasury bills, certificate of deposits, etc. These are open-ended short-term debt schemes as per SEBI mandate. These funds have the Macaulay Duration (weighted average number of years in which present value of cash flows equals the investment cost in fixed income instrument) of 1-3 years. 

The duration of a fund is closely related to the maturity of the underlying securities of the fund in question. Duration is a measure of impact on fund value based on fluctuations in interest rates in the market. The higher the duration, the higher will be the volatility associated with changing market interest rates, and so higher interest rate risk.

The basic target of such a scheme is to invest in a secured instrument that is not much influenced by the fluctuations in market interest rates and so is less sensitive to interest rate changes. These are relatively stable as compared to long term debt instruments, but slightly more compensating than the Ultra-Short Duration Fund and offer fairly decent liquidity.

How Does Short Duration Funds Work

The investment made by a fund manager for a Short Duration Fund is based on different and varying market conditions. Since there are a wide variety of debts funds and money market instruments available in the market, the manager may choose a highly rated investment in a volatile market while they can opt for low-grade security in a stable market for higher returns. It is very important to note here that there is a credit risk involved in such funds due to changing portfolio, and can also lead to total capital loss, if not managed properly.

As these funds are subject to market risks, the managers usually invest substantially in AAA securities, while a smaller percentage is also invested in low grade but high potential companies. The maturity of different securities is also managed following the Macaulay Duration.

Short Duration funds invest in debt instruments such as corporate bonds, government securities, securitized debt, derivatives, bonds issued by financial institutions and public sector units (PSUs). A part of the portfolio could also be invested in money market instruments such as treasury bills, commercial paper, or certificates of deposits, as these are highly liquid assets and, therefore, create a good counterbalance in any portfolio.

Managers usually charge an annual expense ratio on such funds which need to be tracked for better term returns. The best ratios are ones that are consistently lower than the benchmark and other market peers.

What are the Advantages of Short Duration Funds

Short-term debt funds are best suited for people who are new to the debt market and do not have much appetite for risk but are inclined to fairly decent returns without locking their capital away for long. Following are certain advantages-

• Stable returns in Short Duration due to cycles of interest rate tightening and easing, as compared to bank deposits such as fixed deposits, Ultra-Short Duration Funds or Short-term Mutual Funds.
• Lower risk in adverse market conditions as the downward deviations are low in Short Duration funds owing to the 3-year holding period, making the capital almost preserved, though these are still not risk-free investments per se.
• Useful in hedging equity positions in the portfolio in times of bear market trends.
• Have a good liquidity prospect as there is no lock-in and can be a good source of emergency funds since the investor can withdraw funds anytime as per the need subject to tax implications and exit load, if applicable.
• Low sensitivity to inflation risks, given the SEBI mandate to follow Macaulay Duration.
• Good investment to earn benefits of capital during low market interest rates as the fund value increases due to increasing prices of underlying investments.
• Better Yield to Maturity (YTM) as they can also earn from capital gains in addition to interest/dividend income.
• Short Duration Funds usually have lower default risk as compared to credit risk funds as these are mostly investment-grade securities and any investment in equities which is lower than 65% is not treated as equity but rather as a debt fund.
• There’s no fixed lock-in period/norm as these are broadly unregulated basis credit quality and are dependent upon the fund manager’s self-styled investment pattern as well as the investor’s current portfolio allocation.

Taxation on Short Duration Funds

• Short Duration funds give out regular dividends which are taxable as per the investor’s income tax slab rate. Up until March’21, corporates had to compulsorily pay dividend distribution tax before distributing their accumulated earnings to their shareholders, but now the onus of the same has been shifted to the investors. Therefore, dividend has become taxable in the hands of investors.
• Capital gains are also applicable on Short Duration funds. Capital gain is the difference between the purchase price and the selling price of the units of the fund. Capital gains are taxed depending on the tenor for which an investor holds the units of a debt fund before sale or redemption by the issuer.
• Taxation of short term capital gain on mutual funds is charged on funds at applicable income tax slab rate if held up to 3 years.
• Long term capital gain is charged on funds at 20% with indexation benefit if held for more than 3 years.

Who should Invest in Short Duration Funds

• Amateur Investors can invest in such funds due to these being less sensitive to interest rates and inflation fluctuations in the economy. So, such investors would not have to keep up with the latest developments in the market, as these funds tend to be invariable.
• These funds can cater well to customers with low to medium risk appetites.
• It is suitable for investors wanting to invest for a minimum investment period of a year. However, total duration of investment should not exceed 3 years as investors might be at loss due to minimal capital appreciations.
• Those who want to stably earn regular income through investment can invest in such funds. SWP (Systematic Withdrawal Plan) is a facility that allows investors to systematically withdraw a pre-specified amount from mutual fund investments at regular intervals. This may be, in particular, suitable for senior citizens looking for regular income after retirement.
• Investors looking for an alternative avenue for investment than bank savings, can smartly invest in such funds. It will offer higher returns than fixed deposits, but the risk will also increase marginally. 

Things to be Considered Before Investing in Short Duration Funds

• Investment Horizon: It, basically, means the time period for which the money will remain invested in the mutual funds. Choosing a debt fund basis investment horizon helps in avoiding interim risks of volatility and helps investors achieve desired results. Any investment in debt funds should be considered only if minimum investment horizon is of 1 year, up till 3 years. 
• Risk: Though the mutual funds are regarded as one of the safest investment options, however, there might be risk of investor losing the value of money invested, owing to inflation and market rates of interest. Downside risk is the risk computed considering only negative returns. Thus, the investors should be vary of the potential downside risks before going ahead with their investments. They may take into account previous fluctuations in the market price of the fund and future expectations of changes in the interest rates in the economy.
• Expense Ratio: This ratio, basically, calculates amount of money, out of the total money invested by the investors into the fund, used to meet the expenditure of the mutual funds like salary, research cost etc. Thus, this ratio shows the actual amount of funds that are invested further into stocks and securities.  The investors should prefer investing in funds with low expense ratio as it will directly mean that the fund is efficient in its activities and investors will stand a chance of earning higher returns.
• Entry and Exit load: This is the amount charged by the mutual funds to the new investors before granting entry into or exit from the fund. It is levied, primarily, to compensate existing unit holders for dilution in their stake and to discourage them from leaving. A debt fund with high entry/exit load can be expensive for the investors and thus, should be directly reduced from the expected rate of return to calculate actual return.

Frequently Asked Questions (FAQs)

1. How to Invest in Short-term Mutual Funds with Nivesh?

Any investor can enjoy the benefits of investing through Nivesh in the following easy steps:

• Create an account in Nivesh by providing your basic KYC details. (If you already have an account then just login into your account)
• On your portfolio page click on the Buy New tab at the right top corner of the screen.
• Select the category and choose the funds you want to purchase.
• If you already know the name of the fund to buy, then you can search the particular fund through Quick Order.
• Fill the transaction details and confirm. You can place up to 5 orders in one go.
• You can make payment through your registered account through UPI, Direct Pay, or NEFT/ RTGS , Bank Mandate or Cheque. For same-day NAV, select UPI, Direct Pay or NEFT / RTGS as other payment options may take a few days to clear, Nodal account takes about 1-2 days to clear payment from the approved mandate and cheque takes about 2-5 days in clearing due to which you will not get the same-day NAV.

2. Why Should you Invest in Short-term Mutual Funds?

Short-term Mutual Funds are, probably, the highest paying debt funds in the time range of 1-3 years. They give an average return of 4-5%. The risk exposure is limited because investments are done in high credit-rated securities and the interest rate on such portfolio securities remain fixed. The actual worth of return from these funds change, owing to fluctuations in interest rate in economy. Thus, there does not seem to be any limiting factor for not investing in such securities.

3. Do Short-term Funds have an Exit Load?

Yes, there’s usually an exit load charged on such funds to keep the investments as per the defined maturity of underlying securities and deter premature exiting by investors. There still could be certain funds out there that come with NIL exit load, to incentivize investment in such funds.

4. Can we Invest through SIPs in Short-term Debt Funds?

Yes, one can opt for monthly SIP plans for piecemeal investment in Short-term debt funds, which will create a decent corpus over a duration.

5. What is the Lock-in Period for Short Duration Mutual Funds?

There is no fixed lock-in period/norm for short duration mutual funds as these are broadly unregulated, and so the investor can withdraw their money at any time, subject to exit load and tax implications.