Ultra Short-Term Duration Funds

When it comes to investing, many investors want to go the easy and safer way, i.e., debt funds. However, not all debt mutual funds are used for long-term investment. Some are ideal for short-term needs like building an emergency fund and getting more interest than a regular savings account. That is where the ultra short term duration funds come in. Dive into this blog to learn all about the ultra short term duration funds and when or who should invest in them. 

What are Ultra Short-Term Duration Funds?

Ultra short-term duration funds are a type of debt mutual fund that invests in fixed-income securities such as treasury bills, commercial papers, etc., with a Macaulay duration typically between 3 to 6 months (as per SEBI guidelines). These funds lend money to governments, banks, and companies for a very short period. Due to the short lending period, they are less sensitive to interest rate changes compared to longer-duration debt funds. Thus, they do not face huge price fluctuations. This makes them suitable for investors looking to park money for a few months, about 3 to 6 months. The core benefit of investing in these funds is the aim of slightly better returns than a savings account, without taking on the high risk of an equity mutual fund. However, since they still invest in debt instruments, they carry some credit risk and interest rate risk, though generally lower than many other debt fund categories.

How do Ultra Short-Term Duration Funds Work?

Ultra short-term funds work like any other mutual fund, where the money collected from investors is invested in short-term debt instruments. These instruments include treasury bills, commercial papers, certificates of deposit, and short-maturity corporate bonds. These instruments usually mature within a period of a few months, and fund managers buy and sell securities to maintain the average duration of 3-6 months of the ultra short term duration fund. The fund earns returns primarily through the interest paid by the instruments, and this income is reflected in the fund’s NAV (Net Asset Value). 

Since the fund invests primarily in short-term securities, its price is relatively insensitive to interest rate changes compared to the long-term debt funds. While the fund does not offer fixed returns like fixed deposits, the returns are relatively stable and may vary depending on the interest rates and the credit quality of the instruments held. Thus, this makes an interesting investment option for investors looking to park their funds for a short term, with relatively low volatility, offering a balance between stability and modest return potential.

What are the Factors to Consider Before Investing in Ultra Short-Term Duration Funds?

Investment in ultra short term funds is a good option for investors seeking more or less stable returns and low investment durations. The key factors to be considered while investing in ultra short-term funds include,

• Investment Horizon - Ultra short-term duration funds are suitable for short holding periods, typically 3 to 6 months. If the goal is very short-term (a few weeks), liquid funds may be more suitable. However, if the goal is for one year or more, other short-term debt categories may be better suited. Thus, it is important to always match the fund type with the time horizon to avoid unnecessary risk.

• Credit Risk - These funds invest in securities issued by companies, banks, or the government. If the issuer faces financial trouble, there can be a delay or default in payments. This is called credit risk. Before investing, check the fund’s portfolio quality, i.e., funds that invest mostly in high-rated (AAA or sovereign) instruments generally carry lower credit risk.

• Interest Rate Risk - Although these funds invest in short-maturity instruments, they are still affected by changes in interest rates. When interest rates rise, bond prices can fall slightly, and vice versa. However, because the duration is short, the impact is usually limited compared to long-term debt funds. Still, investors should understand that returns are not guaranteed.

• Expense Ratio - Every mutual fund charges a small fee called the expense ratio. Even a small difference in expense ratio can impact the final returns, especially in short-term investments where margins are lower. Comparing expense ratios across similar funds is important.

• Expected Returns vs Savings Account - Many investors choose ultra short-term funds to earn slightly better returns than a savings account. However, returns can vary depending on market conditions and interest rates. They are market-linked products, so there is no fixed return like a bank FD.

• Liquidity Needs - Ultra short-term funds generally allow easy redemption, and money is usually credited within 1-2 working days. However, they are still mutual funds and not instant-access accounts like savings accounts. Thus, it is important to make sure the emergency needs are planned accordingly.

• Taxation - Debt mutual funds are taxed as per the applicable income tax slab without any indexation benefits. Thus, the post-tax returns depend on the applicable tax bracket. Thus, investors should always calculate returns after tax before making a decision.

How are Ultra Short-Term Duration Funds Taxed?

Ultra short-term duration funds are part of the debt fund category and hence, are taxed in line with all other debt funds and debt security instruments. The Budget 2023 and Budget 2024 introduced drastic changes in the capital gains taxation of equity and debt instruments. While the former budget categorises taxation of debt funds based on the asset allocation of the funds, the latter budget focuses on the tax rates and the major change being the removal of indexation benefits. The tax treatment of returns from ultra short term duration funds is tabled below. 

Who Should Invest in Ultra Short-Term Duration Funds?

Ultra short-term duration funds are suitable for investors who wish to park their money for a short period, typically 3 to 6 months, without taking significant risk. They can be an appropriate option for individuals who have surplus funds lying idle in a savings account and are looking for the potential to earn slightly better returns. These funds may also be considered for building an emergency corpus (while keeping some money in instant-access savings), managing short-term financial needs such as insurance premiums, school fees, or other planned expenses in the near future. Conservative investors who prefer avoiding the volatility of equity markets but are comfortable with relatively low market-linked risk may find this category suitable. However, they may not be ideal for long-term wealth creation or for those seeking fixed and guaranteed returns like a bank fixed deposit. Overall, ultra short-term duration funds are best suited for investors seeking stability, liquidity, and modest return potential over a short investment horizon.

What are the Differences Between Liquid Funds and Ultra Short-Term Duration Funds?

Liquid funds and ultra short term duration funds are both part of the debt fund category and ideal for short-term investment. However, they have a few significant differences to consider when choosing between them. These differences are explained below.

Conclusion

Ultra short-term funds are a practical investment option for investors who seek to invest strategically to earn better returns than a regular savings account, albeit at slightly higher risk. While these funds are ideal for short-term goals, they can also be a good option to hedge against short-term market risk. Thus, when used thoughtfully, ultra short-term duration funds can offer a balance between stability, liquidity, and modest return potential. 

This article focuses on a category of debt funds and its key feature. Let us know your thoughts on this topic or if you need further information on the same and we will address it soon. 

Till then, Happy Reading!

Read More: How to Read a Mutual Fund Factsheet?