Should you invest in Ultra Short Duration Funds?

Ultra short duration funds are the open-ended debt mutual fund schemes that invest in debt and money market instruments which have Macaulay Duration of 3 to 6 months. Macaulay duration is related to the maturity of the debt or money market instruments. Ultra short duration funds usually invest in money market instruments like commercial papers (CPs), certificates of deposits (CDs), Treasury Bills etc. These funds have high liquidity.

Ultra short duration funds are suited for minimum investment tenure of 6 months to 1 year or longer, depending on your risk appetite and investment needs.

Yields of ultra short duration funds

According to the term structure of interest rates, yields of debt or money market instruments increases with maturity. In simple terms, a debt or money market instrument of longer maturity will pay higher interest rate (yield) compared to an instrument of shorter maturity. Since maturities of the underlying instruments of ultra short duration funds are longer than those of liquid and overnight funds, these yields of ultra short duration funds are usually higher than liquid and overnight funds. Just to give you a sense of difference in yields, the yield of 182 day T-Bill is 5.76%, whereas the yield of 91 day T-Bill is 5.09% Bill (as on 24^th June 2022, source: RBI). You can see that the 182 day T-Bill is giving 67 bps of higher yield than the 91 day T-Bill.

Credit spreads

Since ultra short duration funds invest primarily in money market instruments like CPs and CDs, they get credit spreads on yields. Credit spread refers to the higher yields of debt or money market instruments of private issuers compared to yields of Government bonds / securities. Current credit spreads of highly rated 6 month papers (CPs) is 50 – 60 bps over G-Secs (source: CRISIL, as on May 31^st 2022). Spreads of lower rated papers will be even higher but lower rated papers will have higher credit risks. You should look at the credit quality profile of ultra short duration schemes and invest according to your risk appetite.

What are the risks in ultra short duration funds?

• Interest rate risk: Prices of debt or money market instruments have an inverse relationship with interest rates. Prices of debt or money market instruments fall when interest rates rise and vice versa. The interest rate sensitivity of a debt or money market instrument is directly related the maturity or duration of the instrument – prices of instruments with longer durations will be more sensitive to interest changes compared to prices of instruments with shorter durations.
  
  Since ultra short duration funds have short durations (3 to 6 months), the interest rate risk of ultra-short duration fund is fairly low. For example, if the duration of an instrument is 6 months and there is a 50 bps hike in interest rate, the price will fall by 25 bps only. Moreover, if you hold a debt or money market instrument till maturity, then interest rate changes will have no impact on your absolute returns. On maturity of the instrument, you will get the accrued interest and principal. Ultra short duration funds use accrual strategy (hold till maturity) – your investment tenure is at least as long as the maturity profile of the scheme.


• Credit risk: Credit risk of fixed income instruments refers to the issuers’ failure of meeting their interest and / or principal payment obligations. If the issuer defaults on interest and principal payments or if the instrument gets downgraded (gets lower credit rating) then the price of the instrument will be written down. Credit risk is a more severe risk than interest rate risk. Interest rate risk reduces to almost zero if you hold a debt or money market instrument till maturity, but credit risk can cause a permanent loss. While you should be aware of credit risks, you should also understand that an issuer will not necessarily default just because it has a lower credit rating. As mentioned earlier, lower rated papers will give higher yield but you should be aware of the risks and invest according to your risk appetite.

Why invest in ultra short duration funds now?

• We are currently in a very high inflation environment. The retail (CPI) inflation in India is over 7% due to high commodity prices. The RBI is hiking interest rates to control the inflation. RBI has already hiked interest rates by 90 bps this year and more rate hikes are expected.


• Longer duration debt funds will be affected more by future rate hikes compared to shorter duration funds. Since the duration of ultra-short duration funds is 3 – 6 months, effect of rate hikes will be relatively less. These schemes will provide income and stability to your debt portfolio.


• Yields have hardened towards shorter end of the yield curve over the past few months. Relatively high yields and relatively low interest rate risks make ultra short duration funds attractive from risk reward perspective for conservative investors.


• Ultra short duration funds invest in short maturity instruments (3 – 6 months durations). Since yields are rising, ultra short duration funds will be able to re-invest the proceeds from maturing instruments in higher yield instruments. So the YTM of these schemes can go up, giving higher returns to investors.

Who should invest in ultra short duration funds?

• Ultra short duration funds are suitable for those who have an investment horizon of minimum six months.


• In a rising interest rate environment, you can have longer investment tenures (e.g. 1 to 2 years) in these funds because you can benefit from rising yields.


• Investors with low to moderately low risk appetites can invest in these funds.


• Investors can use ultra short duration funds for systematic transfer plans (STPs) too. STP is a facility whereby you can invest a lump sum amount in one mutual fund scheme and then transfer fixed amounts at regular intervals (weekly, fortnightly, monthly etc) to another scheme. If you want to invest in an equity fund but are worried about short term volatility, you caninvest in ultra-short duration fundof the same AMCand invest in the equity fund through STP from the ultra short duration fund. In this way, you can get liquidity and returns from the debt fund and take advantage of the equity fund volatility through rupee cost averaging.

Investors should consult with their financial advisors if ultra short duration funds are suitable for their investment needs.