Modules for Beginners

Debt and Securities

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# Short and medium term funds

4.5

Short and medium term funds - two categories of debt funds that are, quite obviously, classified based on the duration of their investments. But they’re vague terms, aren’t they?

‘Short’

‘Medium’

How do you define what’s short-term and medium-term?

Well, you don’t need to do that, because SEBI has already done that for you. To understand that, we’ll need to first look into one important concept - the Macaulay Duration.

### What is the Macaulay Duration?

Let’s say there are four different bonds: Bond A, Bond B, Bond C and Bond D.

• Bond A costs Rs. 1,000 and has a tenure of 5 years. At the end of the 5 years, the bond pays you no interest. It just gives you the initial investment of Rs. 1,000 back.
• Bond B has a face value of Rs. 1,000 and costs the same. It comes with a coupon rate of 6%, pays interest semi-annually, and has a maturity of 5 years.
• Bond C, with a face value of Rs. 1,000, costs Rs. 1,050. The rest of its features are the same as Bond B.
• Bond D, also with a face value of Rs. 1,000, costs Rs. 970. The rest of its features are the same as Bond B and Bond C.

Now, in the four cases mentioned above, how long do you think it will take to recover your original price? Let’s try to decode that.

• Bond A - 5 years. Since the bond gives you back Rs. 1,000 in 5 years’ time, you will recover your initial cost after that window.
• Bond B also gives you Rs. 1,000 at the end of year 5. But in-between, you receive interest payouts semi-annually. So, you will recover your original cost sooner.
• Bond C may also recover your initial cost sooner than 5 years, thanks to the interest payouts. But since it costs more than Bond B, you’ll take slightly longer to recover the original price.
• Similarly, Bond D may take less time than Bond C and Bond B to recover the original cost.

Simply put, this duration is called Macaulay Duration. Technically put, it is a measure of the time it takes for the price of a bond to be repaid by the cash flows from it. In simpler terms, it is the time taken to receive all the money you invested in the bond by way of periodic interest payments as well as principal repayments.

### Defining short-term and medium-term funds

Here’s how SEBI defines these two categories of debt funds. The essence has been given here, paraphrased slightly to make it easier to understand.

### Short duration fund

• The short duration fund is an open-ended, short-term debt scheme that invests in instruments, each with a Macaulay Duration between 1 year and 3 years.
• In a short duration fund, the investments in debt and money market instruments are done in such a way that the Macaulay Duration of the overall portfolio is also between 1 year and 3 years.

### Medium term fund

• The medium duration fund is an open-ended, medium-term debt scheme that invests in instruments, each with a Macaulay Duration between 4 years and 7 years.
• In a medium duration fund, the investments in debt and money market instruments are done in such a way that the Macaulay Duration of the overall portfolio is also between 4 years and 7 years.

### When should you choose short-term and medium-term funds?

Short-term funds have a slightly longer duration than liquid funds, while medium-term funds have a longer investment tenure. So, depending on your individual requirements and your goals, you may find short or medium-term funds useful.

Generally, short-term funds are ideal choices if you have goals that need to be completed within 1 and 3 years. For instance:

• If you want to take an international vacation in a year or two
• If you’re looking at a major home repair a couple of years later
• If you want to make the down payment on your house in the next year or three

Medium-term funds, on the other hand, can help you preserve your capital and earn interest in the process, while simultaneously proving to be useful for goals with a longer due date, like:

• If you want to start a business 5 years down the line
• If you want to pay for your child’s college education
• If you want to purchase a second home or a holiday home

### Tax implications of short and medium term funds

Just like liquid funds, short and medium term funds also give you capital gains at the end of the maturity period. And based on the length of the tenure, these gains can be short-term or long-term.

In the case of short-term funds, since they come with a Macaulay Duration between 1 and 3 years, the capital gain is generally short-term. And short-term capital gains, as you’ll recall, are taxed at the same rate as the income tax slab rate applicable to you. So, for instance, if you pay income tax at 10% based on your total income, your short-term capital gains from short-term debt funds will also be chargeable to tax at 10%.

On the other hand, with medium-term debt funds maturing between 4 and 7 years, the capital gains from these investments would be long-term, since they are realized after 3 years. And long-term capital gains are taxable at 20% with indexation, or 10% without indexation.

### What are the risks associated with these funds?

Remember how liquid funds came with certain risks, like interest rate risk, inflation risk and credit risk. Short and medium term funds are also prone to these risks. The extent of these risks may vary from fund to fund. Let’s get into the details.

• Interest rate risk

Rising interest rates reduce the prices of bonds, while falling rates drive the prices of bonds up. Now, the longer a bond or a fund’s tenure is, the longer it is exposed to risks from changing interest rates. So, while liquid funds may have negligible interest rate risk owing to their extremely short tenures, short-term debts funds have a slightly higher risk in this regard. And medium-term funds have an even higher interest rate risk.

• Inflation risk

Inflation risk, as you may remember reading about in the previous chapter, is the risk that the interest payments and the maturity repayments from the fund may not be sufficient to beat inflation. If your debt fund has a very short duration, the chances are high that you can estimate the way inflation rates may play out during that time. So, it’s easier to invest in funds that can help beat inflation in the short run.

But for debt funds with longer tenures, predicting inflation gets harder, as does beating it. So, to put it together, the longer the investment tenure, the higher the inflation risk. And by this logic, short-term debt funds have higher inflation risks than liquid funds, while in medium-term debt funds, the inflation risk is even higher.

• Credit risk

Now, this risk depends entirely on the debt instruments that a fund invests in. If a short-term or a medium-term debt fund invests primarily in government securities, the credit risk may be negligible. With debt instruments that carry a high credit rating, the risk isn’t negligible, but it’s certainly very low.

#### Wrapping up

So, that sums up what short-term and medium-term debt funds are all about. Now that you know a fair bit about debt funds, it’s time to explore an interesting concept - that of investing in debt and equity through the mutual fund route. That’s what hybrid funds help you do. Head to the next chapter to find out more.

#### A quick recap

• The Macaulay Duration is a measure of the time it takes for the price of a bond to be repaid by the cash flows from it.
• In simpler terms, it is the time taken to receive all the money you invested in the bond by way of periodic interest payments as well as principal repayments.
• The short duration fund is an open-ended, short-term debt scheme that invests in instruments, each with a Macaulay Duration between 1 year and 3 years.
• In a short duration fund, the investments in debt and money market instruments are done in such a way that the Macaulay Duration of the overall portfolio is also between 1 year and 3 years.
• The medium duration fund is an open-ended, medium-term debt scheme that invests in instruments, each with a Macaulay Duration between 4 years and 7 years.
• In a medium duration fund, the investments in debt and money market instruments are done in such a way that the Macaulay Duration of the overall portfolio is also between 4 years and 7 years.
• These debt funds also carry inflation risk, interest rate risk and credit risk.