What Are Short Duration Funds?

When investors look for stability with slightly better returns than a savings account or fixed deposit, short duration funds often stand out as a balanced choice. They are a category of short-term mutual funds that invest primarily in debt and money market instruments, offering reasonable returns with limited risk.

Let’s understand what these funds are, how they work, and who they are best suited for.

What Are Short Duration Debt Funds?

Short duration funds, also known as short duration debt funds or short duration bond funds, are mutual fund schemes that invest in debt instruments such as corporate bonds, government securities, treasury bills, and certificates of deposit.

According to SEBI’s classification, these funds maintain a portfolio maturity between one and three years. This limited maturity range helps them remain relatively less volatile compared to long-duration funds, making them suitable for investors with a short-to-medium investment horizon.

In essence, these funds aim to generate steady income with moderate risk by investing in high-quality fixed-income securities.

How Do Short Duration Funds Work?

Short duration funds operate by lending money to companies or the government for short periods in exchange for interest. The fund manager actively manages the portfolio to maintain the desired average maturity and optimise returns.

Here’s how the process works:

1. Investment in Debt Securities:

The fund primarily invests in bonds, commercial papers, and treasury instruments maturing within three years.

2. Interest Income:

Investors earn regular income through interest payments from these debt instruments.

3. Capital Appreciation:

When bond prices rise due to falling interest rates, the fund’s net asset value (NAV) may also increase, offering potential capital gains.

4. Portfolio Rebalancing:

Fund managers continuously adjust holdings based on changes in market interest rates, liquidity, and credit conditions.

Because of this professional management, short duration funds tend to deliver stable returns with limited sensitivity to interest rate fluctuations.

Types of Short Duration Funds in India

In India, there are a few types of short-term mutual funds that fall within the short-duration category or closely resemble it. These include:

1. Short Duration Debt Funds:

The standard category with a maturity profile of one to three years.

2. Low Duration Funds:

Invest in securities with a maturity of six to twelve months. They are slightly less volatile but may offer lower returns.

3. Ultra Short Duration Funds:

Invest in very short-term instruments, typically with maturities between three and six months, ideal for parking surplus funds.

4. Short Duration Bond Funds:

Focus on short-term corporate and government bonds with the potential for moderate income and stability.

Each of these fund types serves different investment goals depending on the investor’s risk tolerance and liquidity needs.

Benefits of Investing in Short Duration Funds

Short duration funds offer several advantages, especially for conservative investors or those with near-term goals.

1. Stability with Better Returns

These funds generally deliver higher returns than savings accounts or short-term deposits, without taking on significant risk.

2. Lower Interest Rate Risk

Since they invest in short-term securities, they are less affected by interest rate changes compared to long-duration funds.

3. Liquidity

Investors can redeem units anytime, providing flexibility without long lock-in periods.

4. Diversification

The portfolio typically includes a mix of corporate and government securities, balancing risk and reward.

5. Professional Management

Expert fund managers handle credit assessment and duration management, saving investors from tracking markets themselves.

These features make short duration funds a preferred choice for investors seeking stability with modest growth potential.

Risks Associated with Short Duration Funds

While relatively safer than equity funds, short duration debt funds are not risk-free. Investors should be aware of the following risks:

Credit Risk:

The fund may invest in lower-rated bonds for higher yields. If an issuer defaults, it can impact returns.

Interest Rate Risk:

A sudden rise in interest rates can reduce the market value of bonds, affecting the fund’s NAV.

Liquidity Risk:

In stressed market conditions, selling bonds may be difficult without a price impact.

Inflation Risk:

The real return (after adjusting for inflation) may be modest, particularly during high inflation periods.

Understanding these risks helps investors set realistic expectations and choose funds that match their comfort level.

Short Duration Fund Returns – What to Expect?

Returns from short duration bond funds depend on interest rate movements and credit quality within the portfolio. Historically, these funds have offered average annual returns between 6% and 8%, depending on market conditions.

For instance:

• When interest rates fall, bond prices rise, boosting fund NAVs.

• When rates rise, returns may moderate temporarily.

However, over a two-to-three-year horizon, returns tend to stabilize, making these funds suitable for conservative investors looking for predictable outcomes.

Who Should Invest in Short Duration Funds?

Short duration funds are ideal for investors who:

• Have an investment horizon of one to three years.

• Seek better returns than fixed deposits but with manageable risk.

• Want to diversify their portfolio with low-volatility debt investments.

• Prefer liquid options for parking emergency funds or short-term goals.

They are particularly useful for individuals in higher tax brackets when used under the debt fund category, especially through systematic withdrawal plans (SWPs).

Short Duration Funds vs Long Duration Funds

In essence, short duration funds are suitable for stability and liquidity, while long-duration funds cater to investors willing to handle higher volatility for better long-term returns.

Taxation on Short Duration Funds

Taxation on short-term mutual funds in India depends on the holding period:

Short-Term Capital Gains (STCG):

If units are sold before 36 months, gains are added to the investor’s income and taxed as per the applicable income tax slab.

Long-Term Capital Gains (LTCG):

If units are held for more than 36 months, gains are taxed at 20% with indexation benefits, which reduces the taxable amount after accounting for inflation.

Hence, investors planning to hold for three years or more can benefit from tax efficiency through indexation.

Conclusion

Short duration funds offer a sensible balance between safety, liquidity, and returns. They serve as an excellent alternative to traditional fixed deposits for investors seeking better yields without taking on excessive risk.

By investing in high-quality short-term debt instruments, these funds help preserve capital while generating steady income. However, investors should evaluate fund quality, expense ratio, and their own time horizon before committing capital.

When used strategically, short duration funds can be an effective tool for short-term goals, cash flow management, and overall portfolio stability.