It is very common for investors to classify all bond funds under one monolithic group. Limited understanding of the unique value proposition that bond funds have to offer, is one of the major reasons contributing to this belief. It is imperative for investors to understand the Indian debt market has a wide array of bond funds depending on the investor’s time horizon that focus on safeguarding his/her principal under a broad range of objectives. Understanding their distinct benefits and the potential value-add will be instrumental in creating a diversified investment portfolio.
With the help of this article, let us aim to decode short term bond funds.
What are short term bond funds?
As the name suggests, a short-term bond fund primarily invests in instruments that have a duration between one to three years. The underlying securities may include Fixed Income assets such as certificates of deposit (CDs), commercial papers, AAA+ rated instruments, government securities etc. Short term bond funds are typically a good entry point for investors who wish to diversify their portfolio with exposure to debt.
Their liquid nature offers investors easier access to their capital. These funds can be, an ideal solution for investors seeking an investment horizon of one to three years and have a moderate risk appetite. However, in case of unprecedented changes or unforeseen macro market movements, fund values tend to showcase volatility.
Why should people invest in short-term bond funds?
1. Relatively less sensitive to rising rates: In a rising rate scenario, the short duration strategy
adopted by these funds has the potential to reduce volatility. Since fund values react less
notably to changes in market rates, these funds provide relatively consistent and stable returns in over interest rate tightening or even easing cycles. Furthermore, when the rates are rising, the proceeds of the short maturity papers can be redeployed in bonds with higher yields; thereby improving the carry of the fund.
2. Ideal for regular debt SIPs: Some payments or expenses, such as premiums, education expenses, and so on, occur at periodic intervals. For such expenses, one must have access to the necessary funds when the payment deadline draws close. Investors may opt to invest in a short term bond fund in a systematic manner to be able to everage available debt market opportunities. Historically, we have seen short term funds demonstrate relatively stable
returns for an investment horizon beyond 12 months.
3. To accumulate and maintain emergency funds: One of the biggest lessons to be learned from the pandemic is that nothing in life can be predicted. Thus, investors have understood the importance of investing money in order to meet financial expectations in case of unforeseen circumstances. An emergency fund, wherever an investor may choose to invest in, should be able to strike a balance between earning interest and allowing easy access to
money. Since short term bond funds are highly liquid in nature, they can be used as a source of emergency funds to meet any immediate financial requirements.
Before investing in a short term bond fund, it is imperative for investors to evaluate them on three key parameters – return, risk, and expenses. To understand the risk exposure in a given fund, investors need to analyse the underlying portfolio details. If the fund manager holds a relatively large corpus in securities with a credit rating below AA, the fund may be exposed to higher credit risk. Those who are not comfortable with such risks, can opt for funds that invest in either AAA or AA rated instruments.
It is advisable that investors stay invested in short term funds till maturity to avail the benefit of indexation. Furthermore, it will also help them potentially combat interest rate risk (risk that arises from fluctuations in interest rates). Short term bond funds are also known to experience volatility periodically and may also witness lower returns during periods of a steep rate hike cycle. It is recommended that investors factor in this parameter in their investment decisions and consult their financial advisors, accordingly.
(The author is the co-head of fixed income at Axis Mutual Fund)