When RBI keeps the key interest rates stable for a long time, the short-term debt funds stand a better chance to post higher returns than the medium term and long-term funds. These funds are essentially meant for low-risk investors who want a regular flow of income from the securities which do not get influenced by the frequent swings in the bond market.

Let us understand what are short term debt funds and what are the key benefits of investing in them.

The experts advise that the investors should go for high-quality debt funds which have AAA credit rating such as IDFC Bond Fund and Kotak Short Term Fund (STF).

Constituent securities

Short term funds tend to invest in debt and money market instruments which include certificates of deposit (CD), corporate bonds, debentures, treasury bills and government bonds. But it is maximum for one to three years that these investments are made.

These funds get their returns primarily from the interest accrued on bonds/ debt. These funds stand a better chance to earn gains when compared with medium and long duration funds from interest rate hikes.

“Investors who are looking at a 1-3 year horizon and are concerned about interest rates going up, should consider investing in Short Term Debt funds given the attractive Yield- duration combination these funds offer,” says Abhishek Dev, Chief Business Officer, Trust MF.

The short-term debt funds are less vulnerable to loss of value in case of rising interest rate situations. When the central bank raises interest rates, the bond yields follow suit, and bond prices fall as an upshot.

Exercise caution

Before you decide to invest in short term debt funds, make sure to go through the returns of past few years. This is, in fact, a standard practice that must be followed before making any small or large investment in any mutual fund.

The historical returns of mutual funds give a fair idea of how the portfolio has performed in past. This can be seen as an indication of future performance.

Aside from the past returns, do not forget to check the credit worthiness of funds through credit ratings of debt instruments of constituent securities. For instance, sovereign debt papers and debt securities with AAA ratings are more reliable than those with poor ratings.

So, we can summarise that in the stable interest rate scenario, investors can explore the option of investing in short-term debt funds to earn higher returns in case of rate hikes in future.