What are short term debt funds?

Updated: Wednesday, July 17, 2013, 13:05 [IST]

Short-term debt fund is an investment option for individuals interested to invest for a shorter duration. The short-term debt funds also referred as income funds is a mutual fund scheme with a shorter holding or maturity period of less than 3 years. Such funds typically invest in debt instruments such as bank paper (Certificate of deposit), corporate paper and government paper.

Pros and Cons of investing in a short-term debt fund

1. Shorter maturity term renders short-term debt funds less sensitive to changes in interest rates

While the debt theory infers that the market value of debt decrease with increase in interest rates and vice versa, short-term debt funds are only marginally impacted in value with changes in market interest rates.

Further, such debt funds in general may perform comparably better when interest rates in the market head southwards. Less sensitivity of short-term debt funds to interest rates, in turn, assures of safe and stable returns.

2. Flexibility

Such investments provide flexibility and enable an investor to make an exit as and when there is requirement for funds at no costs. In this respect, short-term debt funds score over fixed deposits that charge on early breakage of term deposits with the bank.

3. Tax efficient

Gains on short-term debt funds with maturity term of over a year attract lesser tax for assesses falling under high-tax bracket as against tax that is charged on interest income on bank fixed deposits.

Risks associated with short-term debt funds

Like, every other financial instrument, short-term debt funds bear an inherent risk.

1. Interest rate risk

In general, interest rate changes in the economy, tend to impact short-term debt funds. Nevertheless, due to the shorter maturity period, the value of such funds register only a marginal change.

2. Credit risk

In case, the company managing the short-term debt funds or the issuer of the financial instruments in which the funds are invested default, the investor has to confront the default risk. So, while investing a common investor should factor all such considerations. Generally, the fund however, invests in extremely safe instruments which are highly rated.

3. Inflation-rate risk

The investment in short-term debt funds hold suitable only when the investment horizon of the investor is small, say 2 or 3 years. As only then it is able to provide suitable returns. Otherwise, for a longer term, an investor can consider investing in equities that would provide better returns and offset an increasing inflation rate.

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