Short-Term Debt Funds Gain in Favour

The hike in the repo rate by 250 basis points (bps) by the Reserve Bank of India (RBI ) since May 2022 has significantly benefited short-term debt funds, also termed income funds.

In May 2023, short-term debt funds witnessed an inflow of Rs 4,055 crore. Investors are parking their money in short-term debt funds due to the flattening of the yield curve.

Short-term debt funds invest in debt and money market securities such that the duration of the fund portfolio is between one and three years. Such funds are capable of delivering better returns across rate cycles. Also, short-term debt funds have the potential for higher accruals and higher capital gains.

In the past three years, the highest rate offered by short-term debt funds is 10.13% per annum. In fact, returns from the debt mutual funds across the board have improved significantly in the past four-five months.

Considering that short-term debt funds have shorter maturity periods, such funds are comparatively less influenced by changes in interest rates.

As per the debt theory, with the dip in rates of interest, the market value of debt spikes and vice-versa. Generally, any change in market interest rates has a marginal or insignificant effect on short-term debt funds, allowing such funds to perform relatively better.

Moreover, short-term debt funds tend to offer greater flexibility and investors have the option of exiting the fund as and when they require funds to address any contingency.

For an investor, profits earned from short-term debt funds, which have a maturity period of over a year, will attract lower taxes, especially for individuals who fall under the higher tax bracket.

These funds are suitable for investors who are eyeing liquidity options while earning income via interest payments on debt security investments. This includes investors with low-risk appetites who are on the lookout for investing in a mutual fund scheme that matches their moderate risk profile.