Debt funds are popular mutual funds for investors who want to invest safely and protect their funds from the equity market’s volatility. The debt funds invest primarily in the money market instruments like bonds, treasury bills, and certificates of deposits. The Securities and Exchange Board of India (SEBI) has divided debt funds into sixteen categories.
Ultra short-term funds are placed midway from the overnight or liquid funds and other debt funds. We will explore everything about ultra short-term debt funds, the advantages of investing, and investing profile.
What are ultra short-term funds?
As the name suggests, these schemes have a short investment duration of three to six months. These funds invest in debt instruments of shorter tenure, so the Macaulay duration of the funds is at most six months. Although these are low-risk funds, ultra-short-term mutual funds are slightly above the liquid funds in the risk spectrum. These funds are best suited for conservative investors and investors wanting to invest for a specific financial goal.
These funds generate an average return of 7-9 percent.
Advantages of ultra short-term funds
Investing in ultra-short-term debt funds offers several benefits.
- These are ideal for investors wanting to park their capital for a short period – a couple of weeks or a few months.
- A loss arising from changing interest rates is nearly zero if someone invests for less than three months.
- The returns from these funds are comparable to the bank’s fixed deposit of similar investment tenure.
Who should invest in ultra short-term funds?
These funds are designed to offer high liquidity within a short period. Since the Macaulay duration of these funds is between three to six months, these are best suited for short-term investment. Investors can park their money in an ultra-short-term fund that offers a higher return than a bank’s savings account.
However, you must find a fund that fits your overall financial and investment plan. Individuals may research the market for the best ultra short-term fund before investing.
Factors to consider before investing
Here are some factors investors should consider while investing in ultra-short debt funds.
Risk and return:
Ultra-short funds carry three common risks to all debt funds.
It refers to the risk of default by the issuer of the underlying debt.
Interest rate risk:
It is a risk that is associated with a change in interest rate.
The fund house does not have sufficient funds to meet redemption requests from investors.
Since the return from these funds is less than equity funds, investors must try to reduce as many costs as possible to maximise their gains. The expense ratio is a fee levied by the fund management company for offering fund management services.
Before investing in a scheme, you must clearly define your investment objectives, financial goal, and risk appetite. These funds are crafted to suit the needs of conservative investors to generate low-risk returns and offer quick liquidity.
Investors must find the best ultra-short debt funds to minimise credit risks. So, they must choose funds with high-rated securities to minimise credit risks. Consistency of the fund through different interest rate cycles is another critical component. An experienced fund manager will ensure the fund performs optimally in a changing interest rate regime.
Investors with short-term financial goals or who need a systematic transfer plan (STP) can invest. These funds have a duration longer than liquid funds. Hence, they allow investors to plan for their short-term financial goals. Also, you can set up a systematic transfer plan with an ultra-short-term fund before moving your fund to riskier options like equity funds.
Individuals seeking regular monthly income can park a portion of their retirement fund to generate stable returns.
Taxation on ultra-short-term bonds
It is worth noting that when you invest in mutual funds, the capital gain from your investment will attract capital gain tax. The tax rate depends on the duration of your investment. Based on the tenure of your investment – short-term or long-term capital gain tax will apply.
Short-term capital gain from these funds is added to the investor’s total income and taxed as per the income tax slab. The long-term capital gain tax rate is 20% with indexation and 10% without indexation.
After learning about ultra short-term funds, it’s time to explore the best ultra short-term funds. If it is difficult for you to make financial decisions alone, you can always go to financial advisors, who will help you select the best investments depending on your short and long-term financial goals.