Income Vs Short-term Fund

I'd like to invest in a fixed income fund for a year. Should I choose a short-term debt fund or an income fund? How different are these from medium-term debt funds? Should I consider those too?
Ashok Pradhan

There are some confusing terms in the language that is normally used while discussing mutual funds in India. The terms 'income funds' and 'medium-term debt funds' actually mean the same. Although such funds can take long-term calls on interest rates by investing in debt with long maturity periods, they largely maintain a medium-term portfolio, and are hence called medium-term debt funds.

Coming to your main problem, short-term debt funds and income funds are meant to cater to investors with a different time horizon. Income funds are for the long-term investment of at least a year or so, while short-term debt funds are suitable investment avenues for periods less than that.

In the past one-year, an average income fund has delivered a return of 7.61 per cent, whereas short-term debt funds gave 5.82 per cent return as on April 30, 2004. However, in the six months ending April 30, 2004, short-term debt funds have outperformed income funds (2.34 per cent versus 2.18 per cent).

Thus, if you are a conservative investor, go for the short-term debt fund. Otherwise, an income fund is the ideal investment for one-year investment period. However, the risk is high in income funds as can be seen from the 6-month return. If bad periods in debt market continue for long, you may end up getting less than the short-term debt funds or may even end up getting nothing. But, at the same time, upside potential is also high here. Thus, if you can handle slightly higher risk, opt for the income funds.

What makes them so different? The answer lies is their average portfolio maturity. Income funds invest in longer-tenure instruments like government securities and corporate bonds, and their average maturity lies in higher band of 5 to 8 years. Whereas short-term funds confine their portfolio to short-term instruments like commercial papers, short-term bonds and money market instruments. Thus their average maturity largely remains in the 1-2 years range. This relatively higher maturity of income funds makes them more susceptible to interest rate risk, thus making them more volatile. However, this volatility gets nullified over a longer period of time.

This article was originally published on May 27, 2004.