If you wonder why SEBI has provided 16 classifications for debt funds, it is because of the kind of variety that debt funds offer. From an overnight fund to a 10-year fund, you have debt funds with a plethora of maturities. Similarly from gilt funds to credit funds you have a complete spectrum of choice when it comes to credit risk. It is this wide choice and flexibility that makes debt funds so useful to investors. One such product in the debt fund array is short term bond funds (STBF). Let us understand the concept of investing in short-term bond funds as well as the key benefits of STBFs from an investor’s perspective.

What are short term bond funds all about?

A short term bond fund is a debt mutual fund that normally invests in short term debt instruments with a maturity of up to 3 years. These funds will typically invest in Certificates of Deposit (CD), Commercial Paper (CP) and government securities with a residual maturity of less than 3 years. Of course, these short term bond funds prefer to maintain a large exposure to government paper as they are more liquid and do not pose any execution risk, unlike in the case of corporate debt. Unlike what a lot of investors believe, short term bond fund are not assured returns schemes. They can only provide indicative returns based on the average maturities of their holdings. However, unlike long dated government bonds, these funds will benefit less when interest rates fall and also lose less when the interest rates rise.

What are the advantages of short term bond funds?

Short term bond funds are relevant to investors because of their unique advantages. Let us look at some of the key advantages that short term bond funds proffer

When you are looking at a short term bond fund with tenure of about 3 years, you normally compare it with a bank FD. In pure return terms, the short term bond fund can give 100-150 basis points more than the bank FD.

When interest rates are poised to rise, as is the case now in the light of the Fed hawkishness the short term bond funds are more of a defensive play. Longer maturity bond funds are more vulnerable to rise in interest rates and hence short term maturities are preferred.

Most of the short term bond funds typically invest in bank CDs, CPs and government debt of maturity less than 3 years. As a result, liquidity is never an issue as all these instruments are quite liquid in the bond markets and exit should not pose a problem.

The short term bond funds can be very useful for planned commitments. Apart from the returns being predictable, there is no risk of falling short of these commitments. Consider the table below:

ProductTenureApprox YieldCommitmentRisk ProfileMonthly SIPST Bond Fund3 years7.85%Rs.3,00,000MinimalRs.7,400/-

 In the above case, you only contribute Rs.2.66 lakh via STBF SIP and the balance is made available through ST Bond Fund returns and your Rs.3 lakh is available to you with minimal risk at the end of 3 years to meet your commitment.

Above all, you can also use short term bond funds to park your emergency funds as they are highly liquid and also give you that slight return advantage over and above what a liquid fund can provide.

Understanding the tax advantages of a short term bond fund

Apart from the advantages stated above, short term bond funds can also be very tax efficient if held for more than 3 years. You can give that added boost to your post tax returns by opting for dual indexation benefits. Assume you invested in the ST Bond fund on March 27th 2014 and exited on April 03rd 2017 (3 years and 7 days). Here is how it works.

Invest in ST Bond FundAmountCapital Gains TaxAmountAmount investedRs.10,000Index Value in 2017-18272CAGR Yield7.85%Indexed Cost of buyingRs.12,364Value after 3 yearsRs.12,545Indexed capital gainsRs.181Capital GainRs.2,545Actual Tax paid @ 20%Rs.36Index Value 2013-14220Effective tax rate1.41%

As can be seen from the above table, by tweaking your purchase and sale of the short term bond fund around the fiscal year end period, you can get 4 years worth of indexation benefit. As a result the effective tax rate comes down to just 1.41% after considering indexation. This is a far cry from bank FDs where you have to pay your peak rate of tax of 30% without any indexation benefit available to you. It is this combination of steady returns, safety of principal and the tax efficiency that makes short term bond funds an attractive product for investors!