How To Choose Debt Funds For Short-term Financial Goals

Equity funds are super popular among retail investors. Dezerv, a wealth management company, has analysed mutual fund holdings worth over $3 billion (Rs. 25,000). As per their analysis, retail investors with portfolio values of a few lakhs, are aggressive investors with 90%+ allocation to equity mutual funds.

This means debt mutual funds, which manage more assets than equity funds, don’t get the attention of retail investors. They are preferred by HNIs, family offices and other institutional investors. However, even retail investors have short-term investing needs. Say you have a financial goal that’s just about a year away.

For such needs, equity mutual funds are not appropriate. Because we know that for short periods (typically less than 3 years), equity returns are quite unpredictable. It is important for everyone to learn about debt mutual funds to understand their role in achieving short-term financial goals.

What are Debt Funds?

Debt funds pool money from various investors to buy government bonds, corporate bonds, and similar instruments.

Professional fund managers invest the pooled money in appropriate instruments depending on the type and investment objectives of the fund.

Debt funds are generally safer than equity funds and aim to provide steady returns with good downside protection.

The steady returns come from the interest earned by the underlying bonds

How to Choose Appropriate Debt Funds

For simplicity, we will speak at the debt fund category level and not discuss specific mutual fund schemes. The choice of scheme is a more complex topic that deserves a separate writeup(s).

Types of Debt Funds for Short-Term Investing

Short term refers to periods up to 18-24 months.

Let’s look at some debt fund categories that are suitable for various periods:

Overnight Funds

Ideal investment period: 1 day to 1 week

Overnight funds are the lowest-risk mutual funds across categories. 

They invest in high-quality debt instruments that mature in just 1 day. This almost eliminates all the major risks - credit default, interest rate and liquidity.

However, this also means that they generate very low returns that are in line with the returns of very short-term debt instruments.

Liquid Funds

Ideal investment period: 1 week to 6 months

Liquid funds are the most popular mutual funds among corporates. 

Corporates of all sizes usually park their excess cash in liquid funds. This helps them generate some return on their excess cash.

Liquid funds also invest in high-quality debt instruments that mature within 91 days. This significantly reduces all the major risks associated with debt instruments.

Low Duration Funds

Ideal investment period: 6 months to 15 months

Low duration funds are similar to liquid funds but invest in debt instruments with higher maturities. This slightly increases the interest rate risk associated with them but comes down if you stay invested in them for 6+ months.

Money Market Funds

Ideal investment period: 15 months to 24 months

Money market funds invest in high-quality debt instruments that have residual maturity of 12 months.

Types of Debt Funds for Medium-Term Investing

Medium term refers to periods ranging from 24 months to 48 months.

Short Duration Funds

Ideal investment period: 18 months to 36 months

Short duration funds invest in instruments that mature in about 1-3 years. They typically stick to high quality borrowers to keep the credit risk in check.

Corporate Bond Funds

Ideal investment period: 24 months to 48 months

Corporate bond funds invest in only the highest quality borrowers (AAA credit rated) for the short and medium term (up to 5 years).

Banking and PSU Funds

Ideal investment period: 36 months to 60 months

Banking and PSU funds can be considered to be a particular type of corporate bond fund that lends specifically to banks and PSUs.

Banks are considered to be among the most financially prudent institutions making it relatively safe to lend them money. PSUs, on the other hand, get help from the government if they are unable to repay their debts.

Disclaimer : Above mentioned article is a Consumer connect initiative, This article is a paid publication and does not have journalistic/editorial involvement of IDPL, and IDPL claims no responsibility whatsoever.