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Going Short

Taking the current interest rate scenario into account, investing in short-term debt funds has logic…

When talking of short-term debt funds, we know the question that instantly comes to mind. Why are we discussing short-term debt funds when there are other debt categories that have put up better numbers in the recent past?

Point noted
Thanks to the rising interest rate scenario, we have seen liquid funds and ultra short-term funds, as categories, put up better returns over the past one year than the category of short-term funds. For the one-year period ended June 15, 2011, the category average return of short-term funds was 5.96 per cent while that of liquid funds and liquid plus funds was 7.03 per cent and 7.11 per cent, respectively.
The reason for the underperformance of short-term funds is simple, as the interest rates have gone up, the prices of bonds with higher maturity have come down and this has affected the returns of short-term funds which invest in slightly higher maturity papers.
And interest rates will not be coming down in a hurry. With inflation showing no signs of cooling down and the price of crude not dipping either, the Reserve Bank of India (RBI) has maintained its tight monetary stance and is the most aggressive central bank in Asia. It has increased the rates eight times since 2010. In its recent monitory policy review on June 16, 2011, the RBI once again hiked the Repo rates by 25 basis points. In fact, the possibility of further rate hikes cannot be ignored either though maintaining growth with such a stance is a tough balancing act for the central bank.
So does that mean short-term debt funds should be completely ignored for now?
Before we answer that query, take a look at the table Annual returns from debt funds. A look at the long-term track record of such funds puts this category in a different light. Over the three-year period ended June 15, 2011, short-term funds delivered 7.75 per cent while liquid funds and liquid plus funds, as a category, delivered 6.17 per cent and 6.74 per cent, respectively.
In 2008, when interest rates came down towards the end of the year, short-term funds outperformed both the categories and delivered 10.92 per cent. The performance was repeated in 2009. So it’s not going to be a situation where such funds will always underperform the other debt categories.

The composition
What sort of funds fit into the short-term debt category?
There is no clear definition for such funds (as there is in the case of liquid funds or gilt funds), but as the name suggests, these funds invest in debt paper with a shorter maturity. So you will see such portfolios sporting instruments like Certificates of Deposit (CDs), Commercial Paper (CP), bonds and money market instruments. Basically, instruments that have a stated maturity profile ranging between six to 18 months.
That does not mean they stick to such profiles always. There have been instances of short-term funds taking aggressive bets to fetch more returns and, in some instances, going almost fully into cash. BNP Paribas Short Term Income gives us a classic example. It increased the average maturity of the portfolio of the fund to as high as 7.69 years in January 2008. On the other hand, the average maturity of JP Morgan India Short Term Income did not exceed 3 months over the five months ending April 2011. While returns may be generated with such bets, such moves defy the purpose of short-term funds. Their main aim is to deliver slightly higher returns than liquid funds with lesser volatility than income funds. Taking strong maturity bets makes them more volatile and investing in cash or cash equivalents lowers the returns.
Looking at the practical scenario, we have classified short-term debt funds on the basis of their actual portfolio; those with the average of portfolio maturity over the past six months ranging between one and 4.5 years. Currently, as per the last declared portfolios (June 2011), the average maturity of the funds in this category range between 0.35 years (Pramerica Short Term Income) and 2.72 years (SBI Short Horizon Debt Short Term).

A historical perspective
Such funds were launched in an era of falling interest rates and proved to be a very attractive investment avenue at that point in time. In December 2000, Standard Charted Mutual Fund launched Grindlays Super Saver Income Fund, the first short-term debt fund. But as interest rates began to go up from 2004 onwards, investors opted for more conservative funds - liquid funds, to be more specific. To add to the woes of this category, it was the confused positioning of these funds that led to their unpopularity.
Initially, short-term funds were launched to fill in the gap between a liquid fund and an income fund. Liquid funds were meant for minimum risk with lower returns while income funds offered higher risk (and subsequently higher returns) due to longer investment duration. But soon after their launch a new category of debt funds - liquid plus - was introduced. These funds invested in slightly higher maturity papers than liquid funds but lower than that of short-term funds. Hence they were less volatile compared to short-term funds but had the same tax advantage as that of short-term funds. So institutional investors, the major investors in debt funds, compromised in returns and opted for liquid plus funds. Moreover, liquid plus funds generally don’t charge any exit load or charge it for a very short period of time (up to 30 days). Investors liked this specially since short-term debt funds charge an exit load for redemptions till around six months.
Hence, despite the fairly good numbers, this category is not significant in terms of assets under its management. Even after more than a decade of existence, short-term funds account for a minority share in the total debt assets. The 28 funds in the category corner a meager share of just 3 per cent of the total debt assets. As on March 31, 2011, the short-term debt category had Rs 14,460 crore under its managent.

Your move
We believe that investment in fixed income funds need to be based on individual investment objectives, investment horizon and risk profile rather than market conditions. In other words, it will basically depend on the time an investor wants to park his money (see Getting it right).
On the other hand, the current consensus is that interest rates are near their peak. Should interest rates begin to fall (not likely to do so in a hurry), yields will go down and funds that are invested in higher maturity papers, such as short-term debt funds, will be the beneficiaries.
Interest rates and bond prices move in opposite direction. If there is fall in interest rates, the price of the bond will rise and vice versa. The rise in price of the bonds will increase the net asset value (NAV) of the fund. A fall in prices will consequently affect the NAV negatively. However, the change is not equal across all debt instruments. Generally, bonds with a higher maturity are more sensitive to interest rate changes than those with a shorter maturity. A bond with a high maturity will see its price change more dramatically than a shorter maturity paper. So, higher the maturity of a debt paper higher is its interest rate risk. But the possibility of higher gains also exists in the case of interest rates falling. That is a good time to be invested in longer maturity debt paper. Therefore, funds that invest in higher maturity paper see their NAVs change more dramatically than those which invest in shorter maturity papers.
As we can see in the graph (Risk & Return), lower the maturity, lower is the risk and lower are the returns. Income funds are the most volatile but at the same time expected to give higher returns. Liquid funds are on the other end; the least volatile with virtually no risk but also lower returns. Short-term funds fall in-between the two categories. Investors looking for debt fund options to park their money for around a year can look at short-term funds. Though they do not offer guaranteed returns like a bank fixed deposit, they are more tax efficient. Dividends from these funds are taxed at a rate of 12.5 per cent and the indexation benefit is available on exiting after a year.