How to choose between a long and short-term debt fund

Managing debt funds is not as glamorous a job as working with equity mutual funds, but it is an important job nevertheless, especially when it comes to protecting the principal investment of investors. Moreover, most debt funds are rated for credit quality by an external rating agency.

Debt funds ensure tax-free returns and lower the tax outgo when compared to other fixed income instruments like fixed deposits etc. They are low-risk when compared to equity as most of them invest only in the highest credit-rated debt paper. Debt funds can be broadly classified in two types, long-term and short-term funds.

In debt markets and debt funds, the risk increases with a corresponding increase in maturity. The longer the maturity of either the security or fund, the greater the risk of valuation loss, as longer maturity securities lose more in value when interest rates rise. In such a situation how does an investor make a distinction between long-term and short-term funds and how does one invest?

In debt funds, investors can make good returns if they can time the movement of interest rates properly. Investors then can make sizeable capital appreciation along with current income. In case investors are looking for current income and principal protection, then short term funds offer the least risk. But then how does one make a choice between short- and long term funds? Investors need to ask three questions before making a decision to invest: What is the time horizon; what is my risk appetite; and what is my investment objective?

The time horizon:

If the investor has a short-term time horizon, then a short-term bond fund or a money market fund (liquid fund) would be ideal, as the capital would be protected and the investor can enjoy current income without being bothered with the vagaries of the daily fluctuations of the bond market. If an investor has a longer time horizon of a year and more, with a higher risk appetite to ride out the vagaries of the bond market over a longer time period , then a long-term fund like an income fund or a gilt fund would be ideal.

Risk appetite:

If you have a conservative risk appetite and abjure excessive risks, seek capital protection and steady income, then a short-term fund would be suitable. Funds under this category would be money market funds, ultra short-term and short-term bond funds which invest in short maturity corporate bonds. On the other hand, an investor who seeks long term capital growth through the strategic movement in interest rates and bond yields should aggressively invest in long-term bond and gilt funds.

Investment objective:

What is the core purpose for which an investor seeks to invest in either long-term or short-term funds. What is the investment objective? Is the investor seeking principal protection before taking a view on markets? Or the investor wants aggressive growth? Answering these questions will determine the path the investor will take while choosing long- or short-term debt funds. So, in conclusion, the decision to invest either in short-term or longterm depends on the various factors listed above. Investors would do themselves a great service if they list out their preferences and objectives and then make an informed decision before investing their hard-earned money.

Source: http://economictimes.indiatimes.com/personal-finance/mutual-funds/analysis/how-to-choose-between-a-long-and-short-term-debt-fund/articleshow/7871026.cms