October 30, 2017 by Anirudh Dar
Mutual funds offer a wide spectrum of investment options for different investment objectives, risk tolerances and investment tenures. While equity mutual funds and balanced funds are very popular among retail investors for long term investments, mutual funds also offer excellent investment options for short investment tenures. The definition of short term and long term can be subjective, but usually tenure of less than 3 years can be called short term tenure. For short term investments, the three most important considerations are:-
Debt funds offer excellent solutions for investment needs ranging from parking funds for just a few days or weeks or a year to even longer periods of 2 to 3 years or even longer.Debt funds are mutual fund schemes which invest in debt and money market securities. It is important to understand that, debt funds are also subject to market risks and cannot give assured returns to investors. However, the risk in debt fund investments is much lower than risk in equity funds. While there are many varieties of debt funds in the market catering to different investment needs and tenures, they can broadly be classified into three categories:-
Liquid funds invest in money market instruments whose residual maturities are usually less than 90 days. These funds, as the name suggests, are highly liquid; redemptions in liquid funds are processed within 24 hours on business days. Many liquid fund schemes also offer instant redemptions (the money will be credited to the investor’s bank account in a few minutes) for transactions made through the asset management company’s (AMC) website or mobile application. Liquid funds have no exit load and so you can redeem your invest partially or fully at any time without any penalty, and therefore is a very good short term investment option in mutual funds.
A very high degree of capital safety can be expected from liquid funds. Liquid funds very rarely gave negative returns even for a week or a day. The historical returns of liquid funds have been much higher than savings bank account interest; liquid fund’s average returns in the last 12 months was around 6%, while interest rate of most savings bank accounts is 4%. Liquid funds are excellent investment options to park funds which lie in your savings bank account. Liquid fund investments can be made for a few days to few weeks to few months. If you intend to remain invested for more than 3 months, then ultra-short term debt funds are better investment options than liquid funds.
Ultra-short term debt funds are also money market mutual funds, which invest in money market instruments whose residual maturities range from 90 days to a year. As such, these funds are suitable investment options for investors looking to invest for 3 to 12 months. Ultra-short term debt funds, like liquid funds, offer high degree to safety, high liquidity, but these funds usually give superior returns than liquid funds. Ultra-short debt funds gave 7% average returns in the last one year. Money market mutual funds (liquid and ultra-short term debt funds) are widely used by companies for their short term investment needs. Retail investment in these types of funds is still relatively low, primarily due to lack of awareness among retail investors, but these funds can be excellent very short term investment options for retail investors also.
For investment tenures of 2 to 3 years, short term debt funds can be good alternative options to traditional fixed income schemes like FDs. Short term debt funds invest in debt securities like Government bonds and Non-Convertible Debentures (NCDs). Short term debt funds, usually, hold the securities till their maturity. Hence, these funds can give relatively stable returns to the investors over the investment tenure irrespective of interest rate changes.
Since these funds invest in securities of relatively shorter maturity tenures (2 to 3 years or less), the interest rate risk (change in fund NAV due to change in interest rate) is low. Yet the NAVs of these funds will be affected (favourably or unfavourably) to a certain extent when interest rates change. However, if you match your investment tenure with the modified duration of the short term debt funds, then the effect of interest rate changes on your total returns should be minimal. Short term debt funds historically have given better returns than bank FDs over similar tenures.
Short term debt funds may be exposed to credit risk; credit risk is exacerbated if the funds have substantial exposure to lower rated NCDs or corporate bonds. Most short term debt funds usually invest in high quality corporate bonds, but if you want to minimize credit risk, you should ensure that funds selected by you invest a vast majority of their Assets under Management (AUM) in Government bonds (no credit risk) or corporate papers of high credit quality (AAA or AA). You can check the credit quality profile of the fund in the fund factsheet.
Some investors may deliberately want to invest in funds, which have some exposure to slightly lower rated bonds because these bonds can give higher yields and consequently, the fund can give better returns. Further, if a credit rating upgrade takes place, the price of the bond increases and this will improve the returns of the fund. The sub-category of short term debt funds which invests in slightly lower rated bonds are known as credit opportunities funds. Credit opportunities funds gave more than 9% average returns in the last one year.
You can invest in these funds if you want slightly higher returns but you should understand the risk factors very clearly and be comfortable with the risk you are taking before investing. Though credit downgrades in debt mutual fund securities are fairly rare, downgrades do take place and when it does, the investors are adversely affected. Therefore, funds which have relatively high credit risks are not recommended for investors who do not have sufficient knowledge of credit risk.
In this article, we discussed different types of debt funds for short term investments in mutual funds. We have purposively left out a particular category of debt fund, long term debt fund, in this discussion because these funds are more sensitive to interest rate changes and hence are more volatile than other categories of funds. We will discuss long term debt funds in a separate blog post, but for short term investments through mutual funds, liquid funds, ultra-short term debt funds and short term debt funds offer wonderful solutions for different investment needs, investment tenures and income requirements.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
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