As the name suggests, Short Duration Funds are debt funds with a short-term maturity period. These funds primarily invest in debt or money market securities with 1-3 years of the investment horizon.

Fund houses allocate the majority of your assets into short-term instruments and the remaining into long-term instruments to balance returns and risk.

These funds have lower interest rate risk and varying credit risk depending on the scheme’s credit rating.

Here’s everything you need to know about these funds.

How Do Short Duration Funds Work?

Short-duration funds invest the majority of the assets in debt and money market securities with 1 to 3 years of Macaulay duration. 

Usually, fund houses create the investment regime to generate income via the accrual of bond yield over the investment tenure.  

You will get both the interest earned and the principal amount by the end of the fund’s tenure. This eliminates the price volatility of the underlying instruments.

For example,

Let’s say the face value of the bond is INR 500 with a 7% annual coupon rate and 3 years maturity period.

Each year, you will get a 7% coupon rate on your principal amount. 

The bond price may change with interest rate movements. But, it will have no impact on your investment if you hold it till maturity. 

Top 3 Advantages of Investing in Short Duration Funds

1. Stable Returns Over The Investment Tenure

Fund managers prefer to hold bonds or money market instruments under the scheme till maturity. By doing so, fund houses accrue the coupons or the interest income that an investor is entitled to receive. 

Debt funds are safer compared to equity funds and the returns are predictable. You can expect stable returns on debt funds. 

We recommend you match your investment tenure with the fund duration to avoid interest rate risk. Staying invested for at least 3 years enables the tax benefit for you. You will only have to pay a 20% tax on the long-term capital gain post-indexation benefit. 

2. Lower Risk

Debt funds have two types of risks- Interest rate risk and Credit risk.

Bond prices are inversely proportional to the interest rate. When the interest rate rises, bond prices go down, and vice versa.

To avoid interest rate risk, you can invest in funds based on the interest rate cycle. Short-duration funds perform well in rising interest rates. They can quickly mature and adapt to the new interest rate. During falling interest rates, long-duration funds perform better. The NAV of the funds goes up with each fall in the interest rate. 

Choosing higher credit rating funds can avoid credit risk. Only invest in funds that have AAA or AA ratings. The risk factor increases as you go down on the credit rating chart.

3. Diverse Portfolio

Short duration funds are best suited for portfolio diversification. These funds invest in various fixed-income securities for a shorter duration.

If you are not ready to lock your investment for a longer duration, these funds are for you.

Things To Consider Before Investing in Short Duration Funds

1. Investment Horizon

Make sure you are certain about the investment horizon that you are looking for. Between 1 to 3 years, you can invest in funds that align with your portfolio.

3-year tenure is not much, so we would recommend keeping at least 3 years of investment horizon while choosing a fund. 

2. Yield to Maturity vs Coupon Rate

The scheme will have a predefined annual coupon rate which remains the same throughout the tenure. 

But, the interest rate keeps changing all the time. Yield to maturity is the annual rate of interest that you will earn from the funds. It could be higher or lower than the coupon rate. 

3. Risk Tolerance

Even though short Duration funds are less riskier, you must analyze the risk tolerance of your portfolio.

Seek guidance from VNN Wealth advisors on how much risk your portfolio can manage. Choose your investments accordingly.

4. Track Record of The Fund and Fund Manager

We would recommend taking a moment to study the performance of the funds.

Though historical data is not the only way to judge a fund as anything can happen with the changing economy. But better to be aware of it.

Fund managers’ strategies and calculations are crucial for the fund’s performance. Check the track record of the fund house/manager along with the scheme itself before investing.

5. Expense Ratio

Fund houses charge you a small fee to handle your investments and to deliver desired outcomes. The fee is called the expense ratio which won’t be much for passive funds but could be higher for active funds.

Compare the expense ratio of various funds in a similar category to stay informed.

Note- Higher expense ratio is not always bad. Sometimes, funds with a higher expense ratio may deliver equally superior returns.

Tax Implications

Taxation on Debt funds has been revised since April 2023.

Now, both Short-term capital gains and Long-Term Capital Gains will be taxed as per the tax slab. 

The indexation benefit on Long-Term Capital Gains is only applicable to hybrid funds with more than 35% exposure to equity funds. 

Read more about mutual fund taxation.

Who Should Invest in Short Duration Funds?

Short-term funds are primarily suited for investors looking for a fixed income. These funds will generate stable returns with low to moderate risks in a short duration.

Investors who are looking for investments shorter than 5 years can go with these funds. You can get the indexation benefit after 3 years of investment tenure.

Conclusion

Short-term debt funds are a great way to generate income without a longer investment horizon. You can choose funds between 1 to 3 years of maturity at your convenience.

You may come across a moderate risk due to interest rate movements. But you can avoid it by holding your investment until maturity.

If you are looking for an option to balance equity funds risk, debt funds can help you. Debt funds have become as famous as FDs because of the lower risk and fixed coupon rates.
So if you are planning to invest in debt funds, don’t forget to explore various options. Get in touch with our advisors to see which funds can align with your portfolio. 

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Credit Risk Funds

Credit risk funds are a type of debt fund that invest the majority of the assets in low-credit quality debt instruments.

Wondering why? 

Debt securities with low-rating may carry a higher risk. But these funds may also generate a superior yield than safer debt funds. 

Fund managers often invest in securities that they think have the potential of getting a credit boost. In the long run, these funds could bring higher returns than your expectations.

Interested to explore? Let’s find out more about Credit risk funds.

How Do Credit Risk Funds Work?

Debt funds come across two primary risks: Credit risk and Interest rate risk.

Credit risk is when the issuer may fail to repay your principal investment and returns. To avoid it, underlying bonds are given a rating based on factors such as: credit quality and the financial performance of a company.

Bonds below the rating AA are considered low-rating, high-risk bonds. 

Safe investors often avoid such bonds to eliminate credit risk.

However, low-rated bonds are not always bad. These bonds have the potential to outperform and boost their credit ratings.

In credit risk funds, fund managers allocate at least 65% of total assets into securities with AA or lower ratings.

Though there is a risk, there is also a possibility of better returns.

These bonds may get a credit boost based on their performance, which also amplifies the NAV. In a longer investment horizon, you may end up getting a higher yield.

Top 3 Advantages of Investing In Credit Risk Funds

1. Potential Of Superior Returns

These funds tend to deliver superior returns because of the risk involved. Investors looking to generate income among debt securities can consider these funds. 

2. Portfolio Diversification

Credit risk funds are a great way to diversify your portfolio. Swadanusar risk on your profile brings higher returns. Explore these funds if your portfolio has some space to take moderate risk.

3. Professional Management

These funds are not easy to manage on your own. Fund managers utilize their expertise to select the right debt funds to invest in. The underlying bonds may crawl up to the higher credit rating, rewarding you with more yield. 

Things To Consider Before Investing In

1. Investment Goals

Do these funds fit in your investment goals for the next few years? 

Don’t forget to recall your investment goals before you invest in any funds. If it fits, you have got yourself a nice opportunity to earn decent returns. 

2. Risk Tolerance

These funds are riskier than other bond funds. Invest only if your portfolio has some space for inviting moderate risk.

Get a complimentary portfolio analysis with us to find out your risk tolerance before you invest.

3. Investment Horizon

Most funds perform better in a longer duration. 

Credit risk funds tend to be highly volatile in the short term. Make sure you are fine with a longer investment horizon to avoid any losses. 

4. Expense Ratio

The expense ratio is a fee that fund houses will charge you for managing your investments. It can be higher for actively managed funds.

Don’t forget to compare the fees and expenses of funds before investing. Often, investors prefer to pay a slightly higher fee if the fund has the potential to deliver higher returns. 

5. Professional Advice

Credit risk funds could be tricky for new investors. If you are still willing to explore them, get professional advice to avoid confusion and possible losses. 

Here are a few things to look for in a financial advisor.

Tax Implications

Taxation on credit risk funds is similar to all other debt funds.

• Tax on Short Term Capital Gains (investment held for < 3 years) = Same as your tax slab.
• Tax on Long Term Capital Gains (investment held for > 3 years) = 20% with indexation benefits.

Who Should Invest In Credit Risk Funds?

Credit risk funds can be volatile and carry high risk. There is a chance of credit rating further degrading instead of boosting. 

These funds are not suitable for investors with low-risk appetites. 

Invest only if your risk profile and investment goals align with these funds. 

Conclusion

Credit risk funds can be a great addition to your portfolio to generate additional returns. Though you will come across a certain risk in the short-term horizon.

These funds are only suitable for investors with a high-risk appetite. We would recommend holding your investment for a longer duration to minimize volatility and losses.

If you are still confused, feel free to reach out to our advisors to plan your investments. 

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Banking and PSU Funds

Banking and PSU funds are open-ended debt funds. 

According to SEBI guidelines, these funds invest at least 80% of the corpus in debt and money market instruments that banks or public sector undertakings issue.

Among all the other debt fund categories, Banking and PSU funds are known to have superior credit quality. 

Investors wanting to explore debt funds with decent returns and lower credit risk can consider these funds.

But before you invest, here are some facts about these funds.

Top 3 Advantages of Investing in Banking and PSU Funds

1. Low Credit Risk

One of the biggest perks of investing in these funds is minimal credit risk. These funds strictly invest in Maharatna and Navaratna companies with AAA ratings on underlying instruments.

These companies have years of performance history and deliver consistent returns.

2. Risk

As mentioned above, these funds have underlying assets having AAA ratings. Investors do not have to worry about credit risk as most instruments are government-backed.

And as far as the interest rate risk is concerned, it’s just a temporary phase. The interest rate can fluctuate the NAV of the debt fund. But the loss you may face during the rising interest rate cycle can be recovered during the falling interest rate cycle. Make sure you hold your investment for a longer duration to surpass the interest rate cycles. 

3. High Liquidity

Banking and PSU funds are often in demand among investors. Due to stable returns and safer investments, many are interested in buying these funds.

It enables higher liquidity for these funds. You can sell them off in case of emergencies.

Things To Consider Before Investing In Banking And PSU Funds

1. Returns on Investment

Debt funds may or may not deliver as much return as equity funds. But they generate superior returns than FD or savings accounts. 

Banking and PSU funds ensure higher security but may not deliver higher returns.

Our advisors would recommend holding your investment for more than 3 to 5 years to earn decent returns.

2. Investment Portfolio

Banking and PSU funds would be a great addition to your portfolio to balance the risk. 

If your portfolio is more inclined towards equity, debt funds can safeguard you from volatility. While equity funds deliver superior returns, Banking and PSU funds offer security. 

3. Investment Tenure

Banking and PSU funds have underlying assets with 1-2 years of tenure. Investors who want to invest in a fund with short-term underlying assets and lower risk can invest in these funds.

Though, irrespective of the tenure of the papers held under these funds, you can hold the investment for a longer duration. Align the investment horizon with your financial goals. In fact, holding your investment for more than 3 years makes you entitled to tax benefits with indexation. 

4. Expense Ratio

The expense ratio is the fee the fund house will charge you for managing your funds.

There is often a misconception that- a lower fee will leave you with higher returns. In reality, it doesn’t work like that.

Often, fund houses may charge a slightly higher fee but will deliver superior returns than other funds in the same category.

While investing in any mutual funds, don’t forget to compare the expense ratio. 

Tax Implications

Tax implications on debt funds have changed since April 2023.

Similar to all pure debt funds, investors have to pay tax on both short and long-term capital gains as per their tax slab. 

The indexation benefit on LTCG will only be applicable to hybrid debt funds with more than 35% exposure to equity.

Who Should Invest In Banking and PSU Funds?

Banking and PSU funds are suitable for investors looking for low-risk short-term investments. These funds are safer than Dynamic Bond Funds or Credit Risk funds.

These funds are also suitable for investors who are not fond of FD but would like similar security. Though these funds could be slightly riskier than FD, they may deliver superior returns too.

Conclusion

All the underlying assets in Banking and PSU funds are government-backed. These funds are also less volatile than equity funds, enabling maximum security. 

You can explore various state-owned companies from various sectors via these funds to diversify your portfolio.

Investors looking for decent returns along with lower risk can go with Banking and PSU funds.

Get a complimentary portfolio analysis with VNN Wealth to see if these funds are suitable for your portfolio. 

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Dynamic Bond Funds

Dynamic Bond Funds are a type of debt mutual fund with a flexible average maturity period. These funds switch between long-term and short-term instruments depending on interest rate fluctuations.

DBF takes advantage of interest rate changes by dynamically altering the allocation to gain optimal returns.

Interested? Read along for more information.

How Do Dynamic Bond Funds Work?

Let’s get into some basics before exploring the DBFs.

Debt funds are a combination of various bonds, commercial papers, T Bills, etc. Each of these instruments has a different maturity period. Combined, the debt funds get the average maturity period of all these bonds.

Whenever interest rates fall, bond prices go up and vice versa. In a falling interest rate scenario, long-term funds perform better. Short-term funds tend to deliver superior returns in a rising interest rate scenario.

Dynamic Bond Funds are designed to deliver superior returns in any interest rate scenario. These funds do not have predefined maturity. 

If the fund managers think the interest rates are falling and may fall further, they will switch the allocation to long-term bonds. Otherwise, they will switch the allocation to short-term bonds. 

In both rising and falling interest rate scenarios, you get optimal returns. 

Top 3 Benefits of Dynamic Bond Funds

1. No Debt Fund Mandate

Most debt funds have to follow an investment mandate. For example, short-term debt funds can only have short-term instruments as a base investment. Long-term debt funds only allocate assets among long-term instruments.

Dynamic Bond Funds do not have any restrictions. Fund managers can dynamically allocate assets among instruments with varying maturity periods.

2. Optimal Returns

Bond prices are inversely proportional to interest rates. There’s always a risk of losing profit when interest rates fluctuate.

Fortunately, Dynamic Bond Funds can shift allocations between different instruments to generate optimal returns.

3. Expert Fund Management

Investors do not have to worry about interest rate scenarios as fund managers take care of everything. Fund managers make the calculated decisions to switch the underlying instruments to deliver superior returns.

Things To Consider Before Investing In Dynamic Bond Funds

1. Fund Manager

As mentioned above, fund managers are responsible for dynamically altering the underlying assets. 

Fund managers’ calculations and expertise are extremely important here. In any interest rate situation, the fund manager’s judgments are ultimately going to decide how much return you earn.

This brings us to the next point.

2. Risk

Returns on Dynamic Bond Funds are comparatively less affected by interest rates. By shifting the portfolio, fund managers can balance the risk to optimize the returns.

However, interest rates don’t always work in your favor. If the fund manager’s strategy fails to align with an interest rate, you may lose profit.

3. Economical and Political Matters

Changes in government policies, prices of oil and gas, and political matters can affect returns on dynamic bond funds. The returns might boost or fall, it could go either way.

It’s always better to be aware of such factors to plan your investment. Economical and Political matters often alter in the short term. You may save the loss by investing for a longer horizon. 

4. Fund’s Track Record

It is advisable to examine the track record of the fund before investing in it. Be it equity or debt funds, check the fund performance across various interest rate cycles.  

For dynamic bond funds, don’t invest via NFO. Instead, invest in funds that have a longer performance history to glance at.

Tax Implications

Post April 2023, tax rules on debt funds have been changed. 

Both Long and Short term capital gains will be taxed as per the investor’s tax slab.

Long-term capital gains are applicable when you redeem your investment after 36 months. Otherwise, short-term capital gains will be applicable. 

Who Should Invest In Dynamic Bond Funds?

Returns on Dynamic Bond Funds rely on ups/downs in interest rates. If you understand the interest rate movements, you can create your own portfolio of bonds. Otherwise, we would recommend investing in existing and well-performing funds.

DBF can be suitable for investors with moderate risk appetite. Beginners can consider DBF at a slightly later stage when the portfolio is stable. We would recommend an investment horizon of 3-5 years or more to gain superior returns. 

Conclusion

Dynamic Bond Funds are one of the riskier debt fund schemes. Its performance depends greatly on the fund manager’s calculations and interest rate movements.

However, these funds can also deliver superior returns. 

Dynamic Bond Funds are not suitable for everyone. But if you are curious about it, reach out to VNN Wealth. Our advisors will help you understand the fund alignment in the interest rate cycle. 

Explore more funds and diversify your portfolio with us.

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Types of Debt Funds

FD vs Debt Funds

Mutual Funds

Gilt funds are debt mutual funds primarily investing in securities issued by a state or central government. 
When the government of India is seeking a loan or funding, they approach the RBI. Reserve Bank Of India lends money to the government by borrowing it from banks or different financial entities.
Fund managers can subscribe to these issued fundings. That’s how the Gilt funds in India work. Fund houses allocate investors’ money into government-issued bonds and securities.
And as the government is involved, these funds are the safest to invest in.
Our team has gathered some tips for you before you make an investment. Read along.

What is the Investment Regime?

Gilt funds have two types of investment options-

1. Varying Maturity- In this type, fund houses allocate at least 80% of total funds to government security of varying maturity periods. You might come across a slightly higher interest-rate risk in these funds.

2. Ten-Year Constant Maturity- Here, fund managers allocate at least 80% of total assets to government securities with a constant duration of 10 years. The interest-rate risk is comparatively lower in these Gilt funds.

Top 3 Advantages of Investing in Gilt Funds 

1. Opportunity To Invest In Government Securities

Individual investors cannot easily invest in government securities. By investing in these funds, you can invest in both state and central government securities.
This will add another diverse investment to your portfolio.

2. No Default or Credit Risk 

Both the government and the RBI will guarantee your repayments. Gilt funds do not have any default risk, which enables low-risk investment.

3. Decent Returns

Gilt funds may deliver superior returns depending on the interest rate. During a falling interest rate scenario, these funds deliver better returns than bank deposits over a longer duration. 

Things to Consider Before Investing in Gilt Funds

1. Investment Horizon

We would always advise keeping an investment horizon of 3 to even 10 years.
Though there is no lock-in period in Gilt funds, you may receive better returns over a long duration. 

2. Risk Factor

Even though these funds have zero default or credit risk, you must consider interest rate risk. 
Know that the NAV of the single unit of Gilt funds may drop during increasing interest rates. Instead of selling, you can use this opportunity to buy more units. 

3. Financial Goals

Two important things that should align with your financial goals are- (A) The maturity period, and (B) The interest rate.
As mentioned above, the rise/fall in interest rate may cause the NAV to fall/rise too. You can avoid high interest-rate risk by understanding the interest rate cycle. 
You can reach out to our advisors to know when is the right time for you to invest. 

4. Expense Ratio

Similar to any other mutual fund, you will have to pay an expense ratio for Gilt funds too. It’s a small fee that fund houses charge to manage your investments.
As per SEBI guidelines, fund houses can only charge up to 2.25% of total assets in the form of a fee.

Please Note That- Low expense ratio is not always good. You can certainly consider paying a slightly higher expense ratio if the returns are worth it. You sure can maximize your gains if the expense ratio is low. But what if the gains themselves are low? 

Taxation On Gilt Funds

You will have to pay tax on short-term capital gains (STCG) and long-term capital gains (LTCG) on Gilt funds. 
After the new tax ruled from April 2023, 

Tax on both STCG (investment held for less than 3 years) and LTCG (investment held for more than 3 years) will be considered as per your tax slab.

The indexation benefit is no longer applicable for pure debt funds. Only hybrid funds with more than 35% equity exposure can benefit from indexation. 

Who Should Invest in Gilt Funds?

Investors who are interested in exploring government securities and wouldn’t mind a longer investment horizon can invest in these funds.
In our experience, if bought at the right time, Gilt funds can compete with equity funds in terms of returns; especially during falling interest rates.

Conclusion

Debt funds have become a popular investment option in the past few years. Investors are willing to explore diverse debt instruments to balance the risk and returns.  
Gilt funds are one of the safest debt funds as there is no default or credit risk. Investors interested in Government bonds and securities should absolutely consider investing. 
Keep in mind that, you may come across interest rate risk. To balance that, hold your investment for a longer duration, at least 3-5+ years.
To know more about Gilt funds and investment options, reach out to us anytime. Advisors at VNN Wealth can help you choose the gilt fund suitable for your portfolio. Evaluate your profile and plan your next investment with us.

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