Decoding Short Duration Funds

Corporates are the most common kinds of investors in fixed income mutual funds. Despite the fact that the situation is changing, fewer investors are interested in investing in debt mutual funds. There might be several reasons for this, as these are rarely as well-marketed as equity and Hybrid Funds. Furthermore, due to the smaller commissions provided on debt mutual funds, even mutual fund distributors are hesitant to market them. However, this is not true for every mutual fund distributor. There are a few that practise selling based on what is best for their clients, but the vast majority of them are motivated by commissions. 

However, investing in debt mutual funds is crucial since it adds steadiness to your total financial portfolio. In contrast to equities, where we must recognise market cycles, we must identify interest rate cycles in Debt Funds. This is not the end of it. In order to be on the right end of the curve, you must analyse the yield curve. Furthermore, keeping a watch on the Reserve Bank of India’s (RBI) policies is critical since they impact bond yields. Selecting debt mutual funds amid rising or declining inflationary conditions is critical, since the wrong choice might have a negative impact on your total returns.

Most investors feel that investing in debt funds is a one-time event, but we believe it is more tactical in nature. This means that you should invest in debt funds based on the yield curve and interest rate cycle to get the most out of them. In the current market environment, when interest rates are rising, investment in long duration funds or funds holding long-term papers would provide terrible returns. In fact, we did a cover story on debt funds in a rising interest rate context, where we examined the performance of several debt fund categories three months, six months, and one year after the RBI’s key policy rate rise. In that analysis, we discovered that investing in floater funds, ultra-short duration funds, low duration funds and short duration funds made greater sense throughout key policy rate rises from March 2010 to January 2014. So, as you may have guessed, investing in short duration funds is critical in the current debt market cycle when it comes to investing in debt funds. However, many investors are not aware of these funds. As a result, in this article, we will decode short duration funds for you.

Understanding Short Duration
Funds Short duration funds are debt-oriented mutual funds that limit their investment portfolio to short-term interest-paying securities. According to the Securities and Exchange Board of India (SEBI), short duration funds are those that invest in debt and money market securities with a Macaulay duration ranging from one to three years. Macaulay duration is simply a measure of the portfolio’s vulnerability to interest rate risk. Because the tenure ranges from one to three years, the interest rate risk is modest to moderate.

Performance of Short Duration Funds
To assess the performance of short duration funds, we calculated the three-year rolling returns of all short duration funds from January 2012 to May 2022. Furthermore, we even went beyond that to comprehend its three-year rolling returns distribution and risk measures.

The accompanying graph shows that the three-year rolling returns of short duration funds have been continually falling. However, delving into the three-year rolling data and comprehending its distribution would allow us to better gauge its performance.

The table above depicts the three-year rolling return distribution of short duration funds from January 2012 to May 2022. As can be observed, short duration funds have never produced negative returns in any three-year period in over 1,779 three-year rolling returns’ occurrences. In reality, it has provided returns ranging from 7 per cent to 10 per cent on 87 per cent of occasions. Furthermore, when we look at its median three-year rolling returns, it was 7.8 per cent, where the highest is 10 per cent and the minimum is 6 per cent. This demonstrates that short-term funds can be a superior substitute for bank fixed deposits.

When we look at the risk indicators of short duration funds, they appear to be less risky because they invest in shorter term papers. Risk metrics such as standard deviation, downside deviation, and maximum drawdown were 1.56 per cent, 1.69 per cent and negative 2.7 per cent, respectively.



The graph above depicts the maximum drawdown of short duration funds. As can be noticed, the average decline in this category was 2.7 per cent. Furthermore, only 9 per cent of the time is the drawdown greater than 0.5 per cent. As a result, short duration funds suffer less drawdown if held until the fund’s average maturity.

Taxability
Because debt funds’ portfolios will primarily consist of debt instruments, all debt funds, including short duration funds, are taxed as other than equity-oriented funds. The gains are categorised as short-term capital gains (STCG) if the investors remain invested for less than 36 months. These profits are added to the investor’s taxable income and taxed at the investor’s normal tax rates. If the units have been held for at least 36 months, the profits may be categorised as long-term capital gains (LTCG) and taxed at 20 per cent (with relevant surcharge and cess) with indexation benefit. Indexation permits the invested amount to be updated for current inflation using the government’s Cost Inflation Index (CII). This lowers the effective tax rate on such funds’ LTCG.

Target Audience
So, the next question is who should consider investing in short duration funds? Short duration funds are appropriate for investors with a one-to-three-year investment horizon. If you prefer investing in bank fixed deposits (FDs), short duration funds are a preferable alternative. This is due to the fact that they can generate higher tax-adjusted returns than bank fixed deposits. If you are a first-time mutual fund investor who is not comfortable with equity funds or even hybrid funds, short duration funds might be a suitable beginning point where you can deploy your maximum assets towards short duration funds and some of it to hybrid funds. And, as you get more comfortable with equity, you may progressively rebuild your portfolio to include a good portion of equity. Because interest rate risk is low, short duration funds often give consistent returns. Furthermore, in a rising interest rate environment, short-term funds tend to outperform the funds holding medium to long duration papers.