Best Debt Funds to Invest in 2021 for Short Term Investors

Investing is not always a marathon. It can also be a 100-metre sprint. Likewise, our goals can also be short-term financial goals, which have a time horizon of one month to three years and long-term financial goals where the investment horizon is more than 10 years.

While equity mutual funds are time-tested and perfect for long-term financial goals and long-term investors, there is still a lot of confusion about which are the best debt funds to invest in 2021 for the short-term.

Despite numerous educational campaigns from market regulators and mutual fund companies, even today, the majority of investors have this misconception that only bank fixed deposits and recurring deposits are ideal avenues for your short-term financial goals. However, this is far from the truth.

There are specific categories of debt mutual funds which can help investors generate higher returns than bank deposits whilst taking a minimal calculated risk.

In this article, we are going to reveal the list of the best debt funds to invest in 2021 for short-term investors.

What makes this list of best debt funds standout from those random compilations on the web is the fact that we are not limiting our research to a single debt fund category. Instead, our list of best debt funds to invest in 2021 is spread across 8 different types of debt mutual funds.

We have divided this list of the best debt funds to invest in 2021 for short-term investors as per two distinct risk profiles:

1. Conservative, i.e. low-risk profile

2. Aggressive, i.e. medium-to-high-risk profile

This list of the best debt mutual funds to invest in 2021 for short-term investors is curated after carefully evaluating every debt fund's maturity profile, credit rating, past performance, risk-adjusted returns, and sensitivity to interest rate cycles.

Before we reveal the list of best debt funds to invest in 2021 for short-term investors, we first need to understand some basic concepts about short-term investing, starting with...

Who is a Short-Term Investor?

Contrary to popular belief, short-term investors are not limited to those with an investment horizon of a few days or months. Any investor having an investment horizon of less than three years is a short-term investor.

The objective of such investors is not remarkable capital appreciation, but to generate superior returns than bank deposits with some element of risk. Short-term investors do not mind foregoing high returns for the safety of capital, hence they are conservative in a sense.

You may classify yourself as a short-term investor if you find yourself in the following situations...

• You are a businessman and want to invest for less than a few days with the freedom to redeem without any restrictions.

• You are saving up for the down payment of a house/vehicle due in a few months.

• You are building a rainy day fund with the intent to keep it a very liquid investment, in case of an emergency.

• You are saving for your child's school/college or tuition fees due in the coming year.

• You are nearing retirement, turning risk-averse, and would like to shift your equity corpus to debt mutual funds.

If your financial goals align with any of the above, then this list of the best debt funds to invest in 2021 for short-term investors will work wonderfully for you.

What are Short-Term Debt Funds?

The universe of short-term debt funds is all-encompassing and each of the seven debt mutual funds carries different investment mandates. For starters, we will look at the broader sub-categories of short-term debt funds that exist.

Types of Short-Term Funds

As per the Securities and Exchange Board of India (SEBI), here are types of debt mutual funds that are suitable for short-term investors...

1. Overnight Fund

2. Liquid Fund

3. Ultra Short Duration Fund

4. Low Duration Fund

5. Short Duration Fund

6. Corporate Bond Fund

7. Banking & PSU Fund

They all invest across varied maturities and risk profiles with exposure to debt and money market instruments such as the following depending on the mandate of the scheme.

• Treasury bills

• Certificates of deposits

• Commercial papers

• Bonds and non-convertible debentures

• Additional tier-1 and tier-2 bonds

• Zero-coupon bonds

• Collateralised Borrowing & Lending Obligations

• Government securities

• State development loans

• Central government loans

But broadly, when we speak about "Short Duration Funds", the fund manager is mandated to invest such that the overall Macaulay duration of the portfolio remains between one to three years, except in the case of Overnight Funds, Liquid funds, Ultra-Short Duration Funds, Low Duration Funds, Money Market Funds, Corporate Bond Funds, and Banking & PSU Debt Funds.

What is Macaulay Duration?

Named after Frederick Macaulay (a Canadian economist who introduces the concept of bond duration), the Macaulay Duration (MD) is the weighted average term-to-maturity of the cash flows from a bond. The weight of each cash flow is determined by dividing the present value of the cash flow by the price.

You see, when an investor invests in a bond, s/he receives coupon payment or the interest income on the bond, usually expressed as a percentage of the face and paid from the issue/investment date until the maturity of the bond. Duration is the time period over which you, the investor, receives coupon payments.

But what is the significance of this? Why must the Macaulay duration lie between one to three years?

Well, simply because it potentially protects your investments from high interest rate risk. Over the short term, predicting interest rate movements is much easier. Shorter MD makes your short-term debt funds less sensitive to interest rate changes, unlike long term debt funds.

In a rising interest rate scenario, short-term debt instruments tend to fare well, and on the other hand, when interest rates are falling, it is the long term debt funds that do well. When interest rates are falling, short-term debt funds go out of flavour because fund managers are keen on locking-in higher rates for the long-term by investing in longer maturity papers.

Keep in mind, yields and interest rates are positively correlated; whereas interest rates and bond prices are inversely related.

Let us now look at the three types of best debt funds to invest in 2021 for conservative short-term investors.

Best Debt Funds to Invest in 2021 for Conservative Short-Term Investors

For our conservative investors, who are interested in 100% safety of capital rather than chasing yields for high returns, we have shortlisted three types of debt funds:

1. Overnight Funds

2. Liquid Funds

3. Banking & PSU Debt Fund

Overnight debt funds invest in overnight securities having a maturity of 1 day. This typically involves investing in Collateralised Borrowing and Lending Obligations (CBLO), T-bills, and other cash or cash equivalents which mature within a day.

This keeps them almost insensitive to interest rate fluctuations. Since the underlying papers usually issued are of such characteristics and devoid of credit or default risk.

Overnight debt funds are perfect for extremely conservative investors to park their surplus cash for the very short term and earn returns similar to the savings account. The best part is that they are highly liquid and carry no exit load. So, you can literally redeem from them on the second day itself without any penalty or restrictions.

Overnight funds are also perfect for businessmen who usually operate a current account with banks and earn a 0% interest rate. They can simply switch to overnight funds where they will enjoy the same liquidity with 3%-4% annual returns.

Here is our list of the five debt funds to invest in 2021 - Overnight Funds Category.

The next category in our list of the best debt funds to invest in 2021 is Liquid Mutual Funds.

Liquid mutual funds invest in debt and money market securities with maturity of up to 91 days only. This helps them keep interest rate risk to a minimum. Typically, liquid mutual funds invest in Treasury Bills, Commercial Papers, Call Money, Certificates of Deposits, and so on.

While treasury bills and certificates of deposits are issued by government or quasi-government entities and are inherently secured in nature, commercial papers are issued by private companies and carry credit or default risk.

This is why our list of the best debt funds includes only those debt mutual funds which have less than 25% exposure to private issuers. This will help our readers earn decent returns while avoiding credit risk.

Here is our list of the five best debt funds to invest in 2021 - Liquid Fund Category

[Read More: Best Liquid Mutual Funds in 2021]

The next category in our list of the best debt funds to invest in 2021 is Liquid Mutual Funds.

Liquid mutual funds invest in debt and money market securities with maturity of up to 91 days only. This helps them keep interest rate risk to a minimum. Typically, liquid mutual funds invest in Treasury Bills, Commercial Papers, Call Money, Certificates of Deposits, and so on.

While treasury bills and certificates of deposits are issued by government or quasi-government entities and are inherently secured in nature, commercial papers are issued by private companies and carry credit or default risk.

This is why our list of the best debt funds includes only those debt mutual funds which have less than 25% exposure to private issuers. This will help our readers earn decent returns while avoiding credit risk.

Portfolio as of 31st July 2021
Source: Axis Banking & PSU Debt Fund Factsheet

As you can see, the fund manager has mostly invested in shorter maturity papers of PSUs such as the Food Corporation of India, Hindustan Petroleum Corporation Ltd, NABARD, etc.

The portfolio construction of a Banking & PSU Debt Fund is done by assessing the fundamentals of the company, the interest rate scenario, and the other macroeconomic factors that shape the yield curve.

The exposure to banks and PSUs almost assures against default or credit risk as historically, the government has bailed out stressed units successfully. Banking & PSU Funds are moderately sensitive to interest rate changes but do experience fluctuations in an uncertain or rising interest rate scenario. However, they do benefit from regular coupon payments and can employ a partial accrual strategy to compensate for the volatility in a rising interest rate scenario.

Banking & PSU Debt Funds are ideal for investors who are looking to invest in safe, secured bonds issued by banks & PSUs with a time horizon of at least 2 to 3 years.

Here is our list of the five best debt funds to invest in 2021 - Banking & PSU Debt Fund Category

[Read More: Best Banking & PSU Debt Funds in 2021]

This completes our list of the best debt funds to invest in 2021 for conservative short-term investors.

We will now shift focus to the best debt funds to invest in 2021 for slightly aggressive investors and a short-term investment horizon. These are investors who do not mind taking moderate to high risk for an additional 1%-2% returns.

For our aggressive investors, we have shortlisted the following categories of debt mutual funds -

1. Ultra Short Duration Fund

2. Low Duration Fund

3. Short Duration Fund

4. Corporate Bond Fund

These four debt fund categories have more than 25% exposure to private issuers which increases their credit risk and hence are suitable for slightly aggressive investors with a medium-to-high risk profile.

A key parameter to analyse before investing in any of the above-mentioned debt fund categories is the credit rating or quality of the underlying papers.

Credit rating is a measure of the credit or default risk of debt instruments and the issuer. These ratings are awarded by independent third-party credit rating agencies after evaluating the financial health, cash flow, future earnings projections, and other financial aspects of the issuer.

A typical credit rating is as under:

Before investing in any debt fund, you must check the credit rating of the underlying papers. AAA rating is indicative of the highest safety. But again, if these papers are mostly issued by private corporations, then there is always an underlying credit risk as credit ratings can be revised overnight.

Best short-term debt funds are those that carry the best portfolio characteristic in terms of the credit rating and the maturity profile. This would more or less safeguard you from the chances of default risk and interest rate risk.

The first category in our list of best debt funds to invest in 2021 for aggressive short term investors is Ultra Short Duration Fund.

Ultra Short Duration Fund invests a majority of its corpus in debt and money market instruments such that the Macaulay duration of the portfolio is between 3 months to 6 months. They are low to moderately sensitive to changes in interest rates and are ideal for investors with an investment horizon of around 6-8 months.

That being said, as the duration is slightly higher, the risk is slightly higher as well compared to a liquid fund.

Here is our list of the five best debt funds to invest in 2021 - Ultra Short Duration Fund Category

The next category of best debt funds to invest in 2021 for aggressive investors is Low Duration Funds.

As per SEBI, Low Duration Funds invest in debt and money market instruments such that the Macaulay duration of the portfolio is between 6 months to 12 months. Hence, what changes here is the maturity profile of the debt portfolio.

Low duration Funds invest in papers with higher average maturity, take slightly higher risk in their portfolio, and hence these are okay for investors with an investment horizon of 6 months to a year. Having said that, you as an investor should keep a strict watch on the credit quality of the underlying papers.

Here is our list of the five best debt funds to invest in 2021 - Low Duration Fund Category

Next up on our list of best debt funds to invest in 2021 for aggressive short-term investors is Short Duration Funds.

Short Duration funds as per SEBI, are mandated to invest in debt and money market instruments such that the portfolio's Macaulay duration is between 1 to 3 years.

Hence, compared to a low duration fund, the maturity profile of the debt portfolio is longer while they can invest in a variety of debt papers, corporate bonds/debentures, government securities, and money market instruments. They may hold the underlying papers till maturity to benefit from regular coupon payouts. And as the duration is relatively higher, the risk is two levels above a low duration fund. If the portfolio quality of a Short Duration Debt Fund is not up to the mark, you could even lose a portion of your principal, since these funds do take some credit risk.

A short duration fund is suitable for an investment time horizon of anywhere between 1 to 3 years, but be ready for low-to-moderate interest risk as well (in a rising interest rate scenario). The returns could be comparable to a 3-year FD. Invest in short duration funds only after ensuring the highest portfolio credit quality.

Here is our list of the five best debt funds to invest in 2021 - Short Duration Funds

[Read More: What Should Investment In Debt Funds For Short Term Look Like?]

The final type of best debt fund to invest in 2021 for aggressive short-term investors is Corporate Bond Funds.

As per SEBI, corporate bond funds must invest a minimum of 80% of their total assets (corpus) in the highest-rated instruments, i.e. AA+ and above. This greatly reduces the credit risk for investors, but as we have highlighted earlier, as long as these papers belong to private issuers, credit risk is an ever-present danger as ratings can be revised overnight.

In corporate bond funds, the fund manager has a free hand over the duration of the underlying assets and this is one of the primary reasons why corporate bond funds face higher than normal interest rate risks. If you wish to seek exposure to the highest rate corporate bond, this category of debt mutual fund would be appropriate. However, you also ought to keep a close watch on the duration of a respective scheme.

If you have an investment horizon of at least 2 to 3 years and want indirect exposure to top corporate bonds, may consider investing in corporate bond funds.

Here is our list of the four best debt funds to invest in 2021 - Corporate Bond Funds Category

This concludes our discussion on the best debt funds to invest in 2021 for both conservative and aggressive investors.

At PersonalFN we believe that any/every investment must be done after carefully evaluating your risk profile, investment objective, financial goals, and the time in hand to achieve those goals. Only then will you be able to align your investments well and earn optimal returns with the best fund selection.

Don't forget, debt mutual funds have been through a rough patch following the Franklin Templeton fiasco. But that does not mean you should ignore or avoid investing in the debt mutual fund category altogether. To invest in the best debt funds, we would recommend you to check the following:

Checklist for Selecting Best Debt Fund to Invest in 2021

• Only invest in debt funds with respectable portfolio characteristics.

• Avoid debt funds with more than 25% exposure to papers issued by private issuers.

• Consciously choose debt funds with major exposure to government or quasi-government papers as there is virtually nil default risk.

• Assess the current interest rate scenario in the country.

• Ensure that your selected debt funds have generated decent risk-adjusted returns by comparing their Sharpe and Sortino ratios against the benchmark and their peers.

• While selecting debt funds for investment, try to match your investment horizon with the maturity of the debt funds underlying papers.

A good debt fund portfolio should be a mix of debt funds that have performed across interest rate cycles, carry the highest credit ratings and are issued by the government or quasi-government entities.

With more than 16 different types of debt funds in India, it is easy for you as an investor to get carried away by the glitz and glamour of high-return generating mutual funds and end up investing in a dud. This is why PersonalFN's DebtSelect is a must for you if you are serious about building a winning debt fund portfolio.

Under DebtSelect, we give high weightage to schemes displaying worthy portfolio characteristics. We avoid debt mutual fund schemes that aim for higher yields by taking undue credit risk with substantial exposure in instruments issued by private issuers.

With DebtSelect, you will get unrestricted access to our research team's analysis and recommendations on different types of debt funds covering factors such as profile and suitability of the fund, performance and other aspects. PersonalFN's DebtSelect provides insightful and practical guidance on which mutual fund schemes to Buy, Hold, and Sell.

If you are serious about investing in a rewarding mutual fund scheme, subscribe to DebtSelect today!

Happy Investing!

Warm Regards
PersonalFN Content & Research Team

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