Short-Term Bond Funds: Risk, Advantages, Strategies

Updated on: Jan 11th, 2022


6 min read

Short-term bond funds are funds that invest in bonds for a duration spanning less than five years. These can be in the form of investments in commercial paper, certificates of deposit, and so on. The interest rates offered by these funds are less when compared to a long-term bond fund as the maturity period of these short-term bonds are limited. We have covered the following in this article:

What are Short-Term Bond Funds?

Short-term bond funds invest in securities that have a maturity period between a year to three years and offer high liquidity. Apart from commercial papers and certificates of deposit, these also invest in government securities and medium and long-term instruments.

Any entity or fund house can issue short-term debt (bonds) including government, corporations for investment and companies rated below investment grade. These are also available in dividend and growth options.  

Risk and Return

Short-term bonds funds have a low-interest rate risk as compared to an intermediate or a long-term bond. This allows them to hold together in adverse market conditions. The point to note is that an investor can lose the principal amount of their investment with short-term bond funds.  

Who should invest in Short-Term Bond Funds?

short term bond fund

This form of investment is ideal for risk-averse investors and seek to enjoy tax-adjusted returns that are better than an FD. Some invest in high credit risk securities like high yield bonds, while others choose to invest in high-risk securities to compensate for the low yield environment. You must check for the fund’s fluctuations as compared to its peers before investing in it.

Strategies for Investing in Short-term Bond Funds

Short-term bond funds offer investors a good investment option if investment prudently.

a) Short-term bond funds can maximise their gains by switching between investing in higher maturity debt scrips at one time, and then move to lower maturity scrips in another time. When the interest is going down, the fund manager may buy longer-tenured scrips when the interest rates are low, and the bond prices go up.

b) Short-term bond funds are known to take a bit of credit risk. They have a considerable portion of their assets in high-quality AAA-rated securities. Still, they also invest a small fraction of their portfolio in some well-managed companies that have slightly weaker credit-rated scrips. This poses a certain amount of risk in case the company defaults on interest or principal payments.

c) These funds use another strategy for the maintenance of their average maturities in a close range and the confinement of the credit risk. This is the right way of creating long-term wealth as it avoids taking on excess risk and brings about a certain amount of stability to the portfolio.

Things to consider before investing in short-term bond funds

Expense Ratio

Understand the costs involved in investing in short-term bond funds. Since these funds are managed actively, there will be an added cost involved as compared to investing in a passively managed fund. Understand how much you would be paying in fees and extra charge before you invest.

Risk Tolerance

If you are averse to taking a high risk and as an investor, you are content with returns that aren’t too high, and this may be the fund for you. Since the fund managers of short-term bond funds pick securities with high credit ratings, there is the least possible if any of the issuers to default.

Tax Implications

It is vital to know your tax standing when investing in any fund. Short-term bond funds give out dividends at regular intervals, which are taxed under the dividend distribution tax slab.

Investment Horizon

As an investor, you will not have to worry about the access to your funds being cut off for long as the ideal investment period for these funds spans between six months to a year.

Exit Load

Before investing in short-term bond funds, you must know that you may be charged an exit load if you choose to exit before the completion of six months or want to opt-out of the scheme within a month of investing.

Advantages of Investing in short-term bond funds

  • Good and fixed returns in less period as compared to funds or investments which give average returns, for example – fixed deposit.
  • A lower degree of risk in bear markets.
  • Less sensitive to inflation as compared to long-term bonds.
  • Highly liquid and easily convertible into cash.
  • Surplus funds can be invested in these bond funds rather than keeping it in the current account.
  • These funds can be a source of emergency funds as they are highly liquid. Short-term bond funds will not provide big or huge returns but can be used by investors who need safety for the invested amount and who are looking for a way to earn yields higher than those available on ultra-low risk investments.

These funds are actively managed and can act as an excellent investment return opportunity for people who are looking out for fixed returns. For more details on various bond fund investment options, visit ClearTax, where we offer carefully selected funds based on extensive research and insights.      

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Quick Summary

Short-term bond funds have a duration of fewer than five years, investing in securities with maturities between one to three years. They offer low interest rates compared to long-term bonds but higher liquidity. They are suitable for risk-averse investors seeking tax-adjusted returns and can be actively managed for better returns and stability. Important considerations include expense ratios, risk tolerance, tax implications, investment horizon, and exit loads.

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