The case for and against short-term bond funds

Updated: Sep 2 2014, 07:41am hrs
Bond funds are bundled together under one single category in the investment arena. However, various options are available under bond fund schemes catering to different objectives of investors, based on time horizon and risk preference; the primary being preservation of capital.

A bond fund invests/purchases bonds of different maturity periods, thus being subject to interest rate risk. Any increase in the interest rate in the economy will have a negative impact on bonds and, thus, their prices will reduce and vice versa. However, the extent of impact varies and is based on the bond duration. A bond about to mature in the near term, i.e., within 1-3 years, will be impacted less than one with a long-term maturity. Thus, a short-term bond fund will invest in those bonds that have near-term maturity. Considering the low risk and lower interest rate sensitivity, returns from short bonds are also moderate.

Why short-term bond funds

It is advisable to go in for short-term bond funds if you are investing for a need that might arise in the short/medium term. Short-term bond funds also serve well as a contingency reserve. These funds can help hedge interest rate fluctuations, if one expects a bear market in bond funds. Short-term bond funds also provide high liquidity.

Risk & yield

Considering that a bond fund invests in lower duration investments, they have a lower interest rate risk compared to the long-term bond funds. Thus, one can consider investing in a short-duration bond fund during unfavourable market conditions. However, it is advisable to check the interest rate sensitivity and the portfolio of a fund before investing, since some funds might have invested in higher credit risk investments. Not all bond funds offer lower risk; hence, it is advisable to check the riskreturn matrix before planning to invest in one. Since the fund offers lower degree of risk, the returns offered are also on the lower side. It is advisable to check on the historical returns and compare within peers and also with the current inflation rate.

Compare before you invest

Before the Budget of 2014, any investment in debt funds that was over and above a year enjoyed long term status. Also, capital gain on long-term investments in debt funds enjoyed indexation benefit. However, as per Budget 2014, an investment in debt will be considered as long term if it has been held for more than three years. Thus, if a person is planning to invest in a bond fund for a tenure less than three years, and the same is not being kept for emergency/contingency, it is advisable to compare the returns with other asset classes like fixed deposits.

Investing in a short-term bond

Short term does not mean lower risk; it is advisable for the investors to check the details of the fund like the portfolio composition, interest rate sensitivity, modified duration, average maturity and yield to maturity.

Anil Rego

The writer is CEO and founder, Right Horizons