Ultra Short Duration Fund - Should you Invest?

There is a category of mutual funds known as Ultra Short Duration Funds (USDFs). What are USDFs? Here’s what you need to know about USDFs before you decide whether or not to take the plunge.

As the name suggests, an USDF is a debt and money market fund with an average duration of three to six months. A stable and less volatile investment option compared to longer term mutual funds, this is a great option for short term liquidity management and parking aside emergency funds. 

You should note that capital gain (STCG) taxes are applicable to debt funds. Says Madhupam Krishna, Chief Business Officer, WealthWisher, a financial planning advisory, “If you hold an ultra-short-term fund for less than two years and withdraw, STCG tax is applicable at 20 per cent while withdrawal post that will qualify for LTCG taxes at 12.5 per cent.” 

How Is It Different From A Liquid Fund? 

A liquid fund has an even shorter investment horizon, with investments in debt instruments maturing within 91 days. Longer the investment horizon, greater the volatility exposure and higher the returns. This implies that USDFs are more volatile but bear higher returns than liquid funds. Says Krishna, “It is important to note that each debt paper bought by a liquid fund has to be of duration less than 90 days whereas USDFs just need to keep the average duration lower than prescribed.” 

Pros

USDFs have lower investment horizons which limits your exposure to interest rate risk. Says Soumya Sarkar, Co-Founder, Wealth Redefine, a wealth management firm, “These funds offer a balance between safety and returns, without the higher risks associated with equity or long-term bond funds.” 

Investing in ultra short-duration funds is a good idea if you need to park funds for shorter periods of about four to nine months. Although returns are not as high as long-term investments, USDFs are a stable option for growing your funds to meet short-term financial goals. Returns are generally significantly higher than keeping your money in a savings account.

Cons

Says Lokesh Manik, Senior Equity Research Analyst, Vallum Capital Advisors , a portfolio management services firm, “Credit risk is the primary risk of investing in USDFs and attention should be paid to the credit rating of the underlying instruments.” While most of these funds invest in AAA or government bonds, USDFs come with the risk of exposure to low rated bonds as well as downgrades in bond ratings. 

Another risk to look out for while evaluating USDFs is that the duration of each individual security need not be within the prescribed category as long the average duration remains in that range. 

The Verdict

Says Manik, “USDFs are a good investment opportunity if you have very precise calls on the interest rate or peaking of stock markets. You can lock in your funds at higher rates today v/s lowering of interest rate in future.” For those trying to grow their emergency funds or foresee expenses in the near future for which they require additional incomes, USDFs are a great option rather than relying on asset liquidation or exiting long term investments to fulfil these cashflow requirements.

You should check the expense ratio, exit load, fund house track record and quality of bonds in the fund before investing.