Short Term Bond Fund – Definition, Benefits, Taxation, and How they work?

Published On: 27-Oct-2020

Debt funds create an investment portfolio of different debt securities, wherein the securities may be chosen as per the broad investment objective of such funds. With a predominantly fixed income securities portfolio, the primary source of returns from such debt funds is the interest income earned by the fund from the debt securities. 

A picture containing diagram

Description automatically generated

Some specific categories of funds may also aim to generate superior returns by betting on the interest rate movements and improving the issuer companies' credit profile. However, in the process, the investors also stand exposed to higher interest rate risk and credit risk against their investments. When the investors are looking for investment solutions for short-term investment needs, it is quite reasonable to consider such funds to mitigate risks. Short term bond funds, or Short Duration funds in official parlance, may be one such investment solution for the investors.

What is a Short-Term Bond fund?

As the name suggests, a short-term bond fund is such a fund that invests in bonds with short-term maturities. As per the classification norms for mutual funds issued by SEBI, such funds must create an investment portfolio with Macaulay duration from one to three years. Macaulay duration measures the sensitivity of the portfolio for the interest rate risk, wherein shorter the Macaulay duration, lower is the interest rate risk for the portfolio. 

Given the prescribed Macaulay duration for short-term bond funds, the investors are significantly insulated from the interest rate risk. Short duration funds have a 10% share within the open-ended debt funds with an AUM (Assets Under Management) of Rs. 1.21 lakh crores as on 30th September 2020 

Source: Association of Mutual Funds in India – AMFI.

Advantages of Short-Term Bond Funds

In short term bond funds, the fund managers enjoy the flexibility within the investment portfolio to choose debt securities of different durations, with the Macaulay duration of the overall portfolio mandated to be within 1-3 years. It allows the fund managers to make reasonable investment decisions on the interest rate outlook to generate better returns. 

Further, the lower average Macaulay duration takes care of the interest risk and, to some extent, the credit risk involved in such funds. The fund managers may further mitigate the credit risk by carefully selecting the securities after in-depth research and prudent diligence. As such, the investors may expect reasonable returns, coupled with stability in the investment portfolio. 

How to Invest in Short Term Bond Funds?

Investing in mutual funds remains the same for the investors, whether they are investing in debt funds or equity funds. One may submit the physical application form at any of the Official Point of Acceptance for mutual funds and may also invest digitally through the website/ mobile app of the mutual fund house or Registrar & Transfer Agent (R&TA). 

Taxation of Short-Term Bond Funds

With a predominant portfolio in debt securities, short-term bond funds provide special rates of taxation if the investment has been held for 36 months or more. Such gains from investment in short term bond funds are classified as Long-Term Capital Gains (LTCG) and are taxed at 20% along with the benefit of indexation. The indexation benefits further reduced the effective tax rate on such gains for the investors. If the investments in short-term bond funds have been held for less than 36 months, the gains are classified as Short-Term Capital Gains (STCG) and taxed at regular tax rates applicable to the investor. 

Note: The tax provisions, as mentioned in the article, are for illustrative purposes only, and are updated as per the Finance Act 2020. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment.