Short Duration Funds

Short term mutual funds have a moderately low interest rate risk and are a good option to park your surplus funds for short durations like a month or two. They are best for those looking for risk asset options as they are mainly debt-oriented mutual funds that are high-yielding but of low risk.

Having an investment horizon of shorter than three months- These funds provide a better option to invest surplus funds into, as they provide higher returns than bank deposits in savings accounts without compromising on the liquidity factor.
Investors are looking for risk-aversion- Since these funds attract low risk due to their shortened maturity of the underlying securities, it is best for investors who want their money to be safe yet earn a good percentage of returns on them. These funds have recorded returns to the tune of 6%-8% as per records.
However, before investing in short term funds, investors should keep the following points in mind:

Ensure that the duration of the fund matches your investment tenure
Check the credibility and ratings of the underlying investment securities in the scheme portfolio
With regard to credit risk management, check the track record of the fund manager and the fund house
Some of the best short term mutual funds include Edelweiss Banking and PSU debt fund- Direct Plan-Growth, Edelweiss Banking, PSU debt fund, HDFC Corporate Bond Fund- Direct Plan-Growth, HDFC Medium Term Debt Fund-Direct Plan Growth, and so on.

Returns- These funds offer better returns in comparison to bank deposits like fixed deposits and savings funds. Also, with the added tax benefits attached to these funds, the overall returns on short term mutual funds work out to be higher than most post-tax returns earned from other investment schemes.
Investment horizons- Since these funds aim to provide lower interest rate risk and offer better tax-adjusted returns, these funds do not invest in instruments that have long-term maturity. They generally invest in money market instruments like commercial papers, bonds etc.
Dividend payout- These funds have an option of dividend payouts, where investors can get monthly or fortnightly returns on their investments.

Regarding the taxation policy, as per the Budget 2020 amendments, the dividends earned on mutual funds is added to the total income and taxed as per their income tax slab. These debt funds are computed in the following manner:

If the holding period of the debt investment is less than 36 months, it is taxed under the individual’s income tax slab and is classified as a short-term investment.
If the holding period of the debt investment is more than 36 months, it is a long term investment with a tax of 20% levied with indexation benefits.
Short term mutual funds can opt for a growth option, where the tax treatment is identical to a bank fixed deposit. Or dividend options where the income from the investment is exempt from tax.

Liquidity risk- There is always an uncertainty of the fund manager not being able to sell the underlying instruments of your short-term funds without incurring a loss, which raises a question on its liquidity factor.
Rick of rising inflation- Short term funds are best for those with a short term financial goal in mind. However, people who want the benefits of rising inflation and are yet to keep their investments to yield good returns under such scenarios should opt for long term equity funds.
Credit risk- There is always a possibility that the issuers of the underlying securities of short term funds may deviate from their promise of paying regular interest and the principal amount on maturity.
Risk of changing interest rates- Various economic and geopolitical factors may affect the probability of the rate of interest fluctuation, even with the best short term funds, as otherwise committed by the issuers of the underlying instruments.

Short term mutual bonds have shorter maturity, and hence they normally offer safe and stable returns.
Short term funds are not market sensitive. Hence, they offer better returns than other funds that are affected by fluctuation in the market.
These funds have high liquidity, which gives the investors the leverage to withdraw their funds in an emergency.
The investors get exposed to various portfolios as their funds get diversified over various debt and money market securities.
There is minimal to no exit load for investors of short-term funds as these funds typically do not charge any fee for withdrawal.