Short Duration Funds

Short duration funds are debt funds that invest in debt and money market securities such that the duration of the fund portfolio is between 1 to 3 years.

To understand how short duration funds work, it is necessary first to understand the concept of duration, as well as how it impacts the funds' investment decisions and returns.

• Understanding Duration:

  The duration of a debt fund measures the extent to which the value of a fund fluctuates in response to changes in market interest rates. Duration represents interest rate risk. The higher the duration, the more volatile the fund value, and the greater its interest rate risk. There is a complex formula for calculating duration, but for most retail investors, it is enough to remember that the duration of a debt fund is closely linked to the maturity of bonds in its portfolio. Funds holding more of long-maturity bonds have higher durations as compared to funds that hold mainly short-term securities.

• Defining Short Duration:

  According to SEBI norms, short duration funds are expected to have durations between 1-3 years. This means that short duration funds can invest in the short term as well as slightly longer-term debt securities. In terms of interest rate risk, short duration funds are positioned at the lower end: higher than liquid, ultra-short duration, and low duration funds but lower than medium and long duration funds.

• Where do short duration funds invest?:

  Short duration funds invest in a range of debt such as corporate bonds, government securities, securitized debt, derivatives, bonds issued by financial institutions, and public sector enterprises. They also hold a part of their portfolio in money market assets such as treasury bills, TREPs, commercial paper, or certificates of deposits, in order to maintain liquidity. There are no credit quality norms for short duration funds; hence these funds are free to invest in lower-rated debt to earn higher yields. The extent of exposure to lower quality debt will depend on a fund's investment style and prevailing credit/market conditions.

• Sources of Earnings:

  Short duration funds earn through interest as well as capital gains. Interest is generated from interest payments on the fund's debt holdings. In addition, when interest rates are falling in the market, the value of securities held by the fund increase, resulting in capital gains. Of course, when interest rates go up, the fund makes capital losses. The extent of capital gains or losses earned by a fund depends on its duration and the movement in market rates at that point. Short duration funds actively manage duration to benefit from changing interest rates. In general, short duration funds that have a higher exposure to long term securities face more capital gains or losses. Funds that maintain durations at the lower end of the 1-3 year range are less likely to make capital gains or losses.

• Moderate Risk:

  Short duration funds carry a moderate level of interest rate risk because they hold relatively more of short-term securities as compared to medium or long duration debt funds. The extent of credit risk varies among funds: some fund managers invest mainly in the highest quality bonds, while others may allocate a significant part of the corpus to AA and lower-rated debt in order to boost returns. However, it must be noted that short duration funds usually have lower default risk as compared to credit risk funds.

• Steady Returns:

  Short duration funds generate reasonably steady returns through cycles of interest rate tightening and easing because fund values do not change much in response to changes in market rates. When market rates rise, the funds earn mainly through higher interest income. They minimize capital losses by switching to short term securities. When market rates decline, short duration funds increase their exposure to long term debt to earn capital gains. Thus, the fall in interest income is made up by higher capital gains.

Short duration funds are more tax-efficient than bank deposits because if the fund is redeemed after being held for more than 3 years, the benefit of indexation kicks in and investors end up paying lower taxes (see section on tax advantages for details).

• Investors with an investment horizon of at least one year:

  Short-duration funds are usually recommended for investors who are willing to stay invested for at least one year; in fact, a horizon of 1-3 years may be better in order to get the best returns. An investor who redeems within a year may end up with capital losses if he or she exits at a time when interest rates are rising. Thus, investors with shorter holding periods should opt for liquid funds or ultra-short duration funds.

• First time investors in debt funds:

  Investors who want to start building a portfolio of debt funds can start by investing in short duration funds. These funds offer market-related returns along with moderate risk. Their returns are usually higher than that earned by liquid or overnight funds, while the volatility of fund value is lower as compared to longer duration funds.

• Investors seeking regular income:

  Short duration funds aim to provide stable returns, as they have a moderate amount of interest rate risk. Investors with moderate risk appetite can allocate some money to short duration funds, and use a Systematic Withdrawal Plan (SWP) to create a stream of income flows. An SWP is a facility that allows investors to systematically withdraw a pre-specified amount from mutual fund investments at regular intervals.

• Investors who want an alternate short-term savings instrument :

  Short duration funds have the potential to earn more than bank deposits because they earn interest income as well as capital gains. They also earn more than liquid or overnight funds as they invest in relatively longer-term debt. In a rising interest rate market, such funds benefit from high short-term spreads. In a falling interest rate market, these funds may take exposure to longer tenor bonds to earn some capital gains.

Short duration funds are the entry-point vehicle for investors who do not mind taking on some interest rate risk in exchange for higher returns. In general, these funds generate stable incomes in the short term. However, fund values can show a lot of volatility if there are unanticipated changes in interest rates. For example, suppose a rate cut is widely expected. Market rates will start declining, and fund managers will increase their holdings of long-term debt. Now, if the RBI unexpectedly pauses in its rate action (neither cuts nor raises rates), yields in the market will correct by rising up again. This will result in a fall in fund value, which will not be reversed until (i) rates decline again and/or (ii) fund value is restored by the accumulated interest income of the fund. Thus, investors must be aware that short duration funds experience periodic episodes of volatility; and this must be factored into their investment decision.

Some short duration funds may carry higher credit risk than others, which may expose the fund to the risk of default and possibly, loss of value. During the recent NBFC crisis, there were instances of value erosion among debt funds due to default on the part of bond issuers. Investors must keep in mind that returns on short duration funds are not assured, and that past performance is no guarantee for future returns.

Investors earn dividend income and capital gains from short duration funds. From the financial year 2020-21, investors will pay tax on dividend as per their tax bracket. Capital gains- or the difference between the purchase price and selling price of the fund- are taxable. How capital gains are taxed depends on the length of time for which an investor holds the units of a debt fund before sale or redemption.

• Short term capital gains:

  If the units of a short duration fund are held up to 3 years, capital gains on sale are considered as short-term capital gains and taxed at the income tax slab rate applicable to the investor.

• Long term capital gains:

  If a short duration fund is sold after being held for more than 3 years, capital gains are classified as long-term capital gain for tax purposes. For long term capital gains, investors get the benefit of "indexation." This means that before calculating capital gain, the purchase price can be increased using an index provided by the Government, thus reducing the final taxable capital gain amount. Long term capital gains are currently taxed at a rate of 20%.

Short duration funds can be evaluated on three main parameters- return, risk, and expenses. Each of these parameters is discussed below.

• Return:

  Short duration funds are usually recommended for investors with a holding period of 1-3 years. Hence, in evaluating the performance of a short duration fund, it is best to track its returns over a 1-year, 2 years, or 3-year period. A well-performing fund will earn higher returns than its benchmark and its peer funds on a consistent basis.

• Risk:

  To evaluate risk, a good starting point is to examine the portfolio details. Funds that hold a relatively larger part of their corpus in securities with a credit rating below AA carry higher default risk but may also earn higher returns. An investor who is not comfortable with the exposure to credit risk should opt for a short duration fund that invests mainly in the highest quality bonds (AA or AAA) and generates slightly lower returns.
  The next step is to track interest rate risk by looking at the trends in fund duration. Short duration funds that actively manage duration expose the investor to greater volatility in fund values, though they may deliver a few extra points of return for taking on additional interest rate risk. Investors must ensure that the fund volatility matches their risk tolerance. Finally, a qualitative assessment should be made based on the management philosophy of the fund manager and the attitude of the fund house towards risk management.

• Expense Ratio:

  Mutual funds charge an annual expense ratio for managing the fund portfolio. Higher expense ratios reduce investor returns because the final return to the investor is obtained after subtracting the expense ratio. Hence it is important for investors to keep track of expense ratios.

• Short duration funds are debt funds that invest in debt and money market securities such that the duration of the fund portfolio is between 1 and 3 years.
• Short duration funds invest mainly in short term securities, with a part of their corpus allotted to longer-term securities. The extent of exposure to long-maturity debt determines their interest rate risk.
• Short duration funds invest in a wide range of debt and money market securities, with no SEBI-imposed restrictions on credit quality.
• Short duration funds earn through interest income and capital gains on their debt holdings.
• Short duration funds funds offer stable returns for moderate risk. Investors with moderate risk appetite can opt for these funds as an alternative to other short-term instruments.
• Short duration funds are most suitable for investors with an investment horizon of 1-3 years, those looking for stable income, first-time investors in debt funds, and those with a moderate appetite for interest rate and credit risk.