Debt funds: a prudent option for short and medium-term investments

Mutual funds are one of the categories of mutual funds that an individual or an institution can consider for their short to medium term needs. Debt funds invest in fixed income instruments such as government bonds, corporate bonds, debentures and many other similar instruments.

A tailored investment approach is extremely important for every individual/company to be prudent and comfortable financially throughout their journey. We need to identify and bifurcate our short, medium and long term financial goals to ensure we have control over them. For short term requirements (up to 3 years), we generally tend to favor traditional fixed return products. For an investment need of as little as 1 day up to 3 to 4 years, there are various funds that can be considered under the mutual fund category.

For an investment need of less than a week, Overnight Funds are the safest option among debt funds. The money is invested in securities with overnight or overnight maturities and is backed by guarantees such as Govt. securities. For this reason, overnight funds carry no market risk generally referred to as interest rate risk. Overnight funds are the best option for institutions to store their excess funds, since current account money earns no interest.

Cash funds, another short-term option, invest money in short-term fixed-yield securities. They are generally considered low risk, as investment is made in high quality fixed income securities with maturities as short as 91 days. The fund is less vulnerable to volatility in the debt market (due to changes in prevailing interest rates), making it suitable for investment needs ranging from 7 days to one year.

Also Read: Public Provident Fund: PPF Account Eligibility, Withdrawal Rules, Tax Benefits – Here’s Everything You Need to Know

There are a few aspects that should be considered before choosing the right debt fund. Depending on the time horizon, investment objective and prevailing interest rate scenario, investors should choose the fund that meets their needs. Investors can choose between overnight funds, liquid funds, very short-term funds, short-term funds and floating rate funds if the investment period is less than 3 years. There are other debt funds like corporate bond funds, dynamic bond funds, regular savings funds, credit risk funds, to name a few. These funds are ideal for investors who can stay invested for a time horizon of 3 years or more. Investors who have a bit higher risk appetite and are not dependent on these funds for a short-term emergency may consider investing in them provided they understand how these funds work.

What are the risks associated with debt funds?

The purpose of investing in debt funds is to generate a slightly better return compared to traditional products. The fund management team takes reasonable precautions in selecting high quality creditworthy securities and diversifying the investment. Although many of these funds are considered reasonably safe, they carry a certain degree of risk. Each fund has a different investment objective. Therefore, the risk it carries and the returns it can generate vary from fund to fund.

Who should invest in debt funds?

Short term requirements: Individuals who have an investment time horizon of up to 1 year. For example, paying tuition fees, insurance premiums, accumulating for annual vacations/trips, etc.

Emergency fund: Individuals can build an emergency fund through the SIP in the Debt Fund. And for those who have already invested in traditional products, you can consider investing some of them in debt funds for tax-efficient returns.

out of sight: For many people, what is not visible in the savings account is generally not taken into account for expenses. For those who want to have control over spending may consider investing debt funds.

Savings bank account lovers: Many of us deposit a reasonable amount of money into our savings bank account. Few debt funds are a tax-efficient alternative for these investors.

Investing in stocks via STP: Liquid funds are often used as a vehicle to invest in equity mutual funds through a Systematic Transfer Plan (STP). This strategy helps reduce downside risk, especially in volatile market conditions.

Companies/Institutions: Money parked in current accounts earns no interest. Plus, when the money at stake is big, even a decimal change in returns matters a lot (of course without trading on risk). A company can plan its cash flow and invest in a combination of different debt funds to optimize its overall return and mitigate the risk of interest rate volatility.

Our thoughts

Debt funds are ideal for investors looking for

• Reasonable returns with low risk
• Short to medium term investment horizon
• Liquidity of a savings bank or a current account
• Tax-efficient alternatives to traditional fixed-return products

Most of the time, we leave a large balance in savings accounts that we hardly use over the years. Since debt funds are taxed under capital gains tax (under current tax rules), it makes sense to shift some of these funds to cash or short-term funds. Unlike interest from savings accounts, the returns from these funds are not taxed until the time of withdrawal. And if the investment exceeds 3 years, withdrawals are taxed as long-term capital gains with the advantage of indexing it to inflation. This makes it an attractive and tax-efficient alternative.

In summary, debt funds can be a prudent option for your short to medium term investment needs. However, fund selection should be done after understanding various aspects such as investment time horizon, expected returns, risk involved, tax efficiency and interest rate cycle. Since these factors keep changing, it is suggested that you take advice from an expert to help you choose the best option.

(By Shreedhara R Bhat, Founder and Director of Ara Financial Services Pvt Ltd)

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John A. Bogar