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Three types of debt funds for short term investing. Take your pick.

Here are the three categories of debt funds– liquid funds, ultra-short term debt funds and short-term debt funds – that will meet most, if not all, your short-term investing needs.

You probably have some idle money in your bank account, which is likely to soon go as a home down-payment. Or may be to pay for an overseas family vacation planned next year. 

Why don’t you consider investing this short-term money in debt funds instead?

Debt funds usually invest in safe and liquid debt instruments. While protecting your capital, they also provide better returns than normally earned from bank Fixed Deposits or small saving instruments.  

There are various types of debt funds available based on your investment horizon and liquidity preferences.

Here are the three categories of debt funds– liquid funds, ultra-short term debt funds and short-term debt funds – that will meet most, if not all, your short-term investing needs. 

Safety 

Liquid funds are the safest among the three categories. They invest in very liquid and high quality investments such as repo, treasury bills, commercial paper, certificates of deposit and non-convertible debentures. The NAV doesn’t fluctuate much as investments are mostly in short-term papers.

Ultra-short term funds take a marginally higher level of risk than a liquid fund.  They hold debt papers that are marked-to-market on a daily basis. While the NAV marginally fluctuates in the process, the returns are slightly higher returns than in liquid funds. It acts as a good ‘parking’ alternative to funds lying idle.

Short-term funds in turn invest in debt papers across the credit spectrum (different quality ratings) but within the investment grade. In addition to earning income from the invested debt instruments, the aim is extra returns from capital appreciation and trading opportunities. They take the highest risk among the three categories.

Investment horizon 


Ultra-short term funds have a slightly longer investment horizon of 3-6 months while it is anywhere from 1-5 years for a short-term bond fund. Longer the duration (or average maturity of its debt papers) of the fund, more is its susceptibility to interest rate fluctuations in the economy. 

It is important to choose a debt fund category that matches your investment horizon. Liquid funds typically invest in debt papers with a maturity of three months or less. Currently, only debt papers with a maturity of over 30 days need to be valued on a mark-to market basis. To the extent a fund is invested in debt papers of less than a month tenure, its income is added smoothly to its NAV. 

Ultra-short term funds have a slightly longer investment horizon of 3-6 months while it is anywhere from 1-5 years for a short-term bond fund. Longer the duration (or average maturity of its debt papers) of the fund, more is its susceptibility to interest rate fluctuations in the economy. 

Tax lucrativeness
Capital-gains tax rates are the same across debt funds. If you sell a fund within three years, short-term capital gains tax as per the marginal tax rate is applicable. Selling after three years means long-term capital gains tax of 20% (after indexation) is applicable. 
Moreover, there is no TDS (unlike bank FD) and capital gains tax needs to be paid only after the redemption.
In the past, investing in debt funds had led to lesser tax outgo than from that of bank fixed deposits. 

Returns
Typically, you can expect debt funds to give one to two percent over the returns of bank deposits, and often inflation. In the last one year, liquid funds and ultra-short term debt funds have given an average return of 6.6% and 6.8% as compared to 4% that banks give on its saving bank account. 

Liquidity
Large penalties are applicable for premature withdrawal in case of fixed deposits. In contrast, graded exit loads are applicable for liquid funds – largely to keep corporate money away. It is applicable only on withdrawing within six days of investing. 
Debt funds are highly liquid and investors can get credit into their bank account within two working days of putting the redemption request. 

Takeaway
Pick and choose debt funds that match your investment horizon. These are best for short term needs of less than 4-5 years. Choose wisely from among reliable and trusted funds, and capital protection should be the least of your worries.

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