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Short-term debt funds belong to the category of funds defined by Sebi as short duration funds that hold debt and money market securities with a duration of one to three years.
These funds predominantly hold debentures and bonds of companies, financial institutions, central and state governments and government-sponsored enterprises. They may also hold some money market instruments such as commercial paper and certificates of deposit and others for liquidity and to benefit when yields are good. The terms to maturities of the instruments held will be such that the duration of the portfolio will not be more than three years.
These funds earn returns from two sources: interest income and gains/loss on the price of the securities in the portfolio. The interest income is known and earned periodically. Any appreciation in the price of the securities adds to the interest income. But a fall in price leads to a loss that will reduce the total returns in the fund. The price of debt securities go up when interest rates fall and vice-versa. The extent of gain or loss in price depends on the duration—higher the duration, greater is the impact.
The returns from these funds are typically not very volatile. However, they are not suited for investors parking funds for immediate use where they would not like to see even a slight and temporary fall in net asset values (NAVs). These are best suited for investors looking to earn more than just interest income and are okay with some interim volatility in the NAV.