The best debt funds to achieve a 2 to 3-year goal

Summary: Think debt funds are always safe? Think again. For many investors, parking money in a debt fund feels like a guaranteed way to earn steady returns without worry. But choosing the wrong fund type can turn “safe” into “sorry”. In this story, we look at the risks associated with debt funds and then identify the category of debt funds that are best suited for a two to three-year goal. We also give you a couple of smart alternatives. So, let’s find out the best debt funds for your time horizon…

Debt funds are often considered safe havens where investors can park their money without fearing significant losses. Compared to equities, they usually offer lower volatility and more predictable returns. However, not all debt funds are created equal. Different categories come with different risk-return profiles, making the choice important, especially when your investment horizon is two to three years.

Understanding duration and debt fund categories

When you invest in a debt fund, one number worth knowing is its duration (technically, Macaulay duration). In simple terms, it’s the average time it will take for you to get back the money you paid through the bond’s interest payments and final repayment.

But duration is not just about time. It also tells you how much the fund’s value will move if interest rates change. The higher the duration, the more the fund’s price (NAV) will swing when rates go up or down. Think of it like a seesaw: the longer the plank, the bigger the swing.

Based on this duration, debt funds fall into three broad types:

• Short-duration funds (1-3 years): Invest mainly in high-quality corporate bonds and government securities that mature soon. They’re less sensitive to interest rate changes.
• Medium-duration funds (3-4 years): A middle path, mixing corporate bonds, government securities, and sometimes slightly riskier papers.
• Long-duration funds (7+ years): Hold mostly long-term government bonds. These can see sharp ups and downs when interest rates move.

So, as the data shows, for an investment horizon of two to three years, short-duration funds strike a balance between returns, credit quality and volatility, making them the most practical choice for this period.

Why short-duration funds are usually the best fit for 2–3 years

They offer a balanced approach. Better returns than liquid or ultra-short duration funds (average three-year returns of 6.2 and 6.9 per cent, respectively), plus lower volatility risk compared to medium- or long-duration funds.

Within this category, look for funds that maintain a strong emphasis on AAA-rated or sovereign securities. This credit quality helps reduce the chance of defaults or credit downgrades, which can cause sudden and steep NAV falls.

Alternatives to short-duration funds for two to three years

While short-duration funds are often the go-to choice, these categories can also be worth considering:

• Target Maturity Funds (TMFs): If your goal is fixed at two to three years, TMFs help lock in yields (check yield to maturity) that mature in that exact timeframe. For instance, a TMF maturing in 2028 with a yield-to-maturity of 7.9 per cent will deliver roughly that return if the fund is held till maturity.
• Banking & PSU Funds: These funds provide slightly higher yields with a quality portfolio mandated to hold more than 80 per cent in bank, PSU and government securities. No fixed duration, so best if your timeline is flexible.
• Corporate Bond Funds: These funds invest at least 80 per cent in AA+ or higher-rated bonds with higher return potential but no duration cap. Suitable only if your holding period is flexible and you can tolerate interest rate swings.

Credit risk: The critical caveat you cannot ignore

While short-duration funds offer the best balance for a two to three-year horizon, remember that credit risk remains the biggest threat. Events like the 2019 DHFL default show why it’s vital to choose funds with strong credit quality and diversified portfolios to avoid sudden NAV shocks.

Additionally, manager behaviour and liquidity management play key roles. In times of stress, funds holding riskier bonds may face liquidity crunches, forcing them to sell assets at steep discounts and worsening NAV losses.

The bottom line

For a medium-term investment horizon, predictability and capital safety should take precedence over chasing a few extra basis points of yield.

Short-duration funds, especially those investing in high-quality instruments, generally offer the best risk-return mix for such goals.

Which is the best short-duration debt fund?

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Also read: 3 reasons debt funds aren't just for retired & boring people