Understanding short-term bond funds

Mutual Funds | admin | April 12, 2011 at 8:40 am

Food inflation is on the way down. But the crude oil prices are still quoting higher, making the market participants fret over a possible uptick in inflation. The Reserve Bank of India (RBI) has yet not hinted about any cut in the key rates. That makes a perfect case for the short-term interest rates to rule in the higher band.

Investors can take advantage of it by investing in shortterm bond funds. Short-term bond funds, as the name suggests, are the mutual fund schemes that seek to generate income by investing in short term fixed income instruments. Generally these schemes invest in certificate of deposits, commercial paper and bonds with less than one year to maturity.

The fund managers prefer to invest in securities with high credit rating. This ensures that there is the least possibility of default by issuers offering safety to investors' capital. Given the shortterm nature of investments, the portfolio as a whole does not carry much of interest rate risk.

The fund works fine as a short-term investment opportunity for those who do not intend to take any risk with their capital but want to earn better tax-adjusted returns than a short-term fixed deposit. The schemes offer dividend payout option that pays dividend at regular interval such as monthly and fortnightly. Dividends paid by these schemes attract a dividend distribution tax at the rate of 13.52% for individual investors.

Interest on fixed deposits is clubbed to the income of the investor and taxed at marginal rate, which in case of highest tax bracket stands at 30.9%. Minimum investment in these funds is Rs 5,000. The ideal investment period for such funds is six months to one year. There is no entry load. But some schemes in this category do charge an exit load if you were to exit before one month or six months. Hence before stepping in check the exit clause.

If you are a very short term investors, it is better to invest in liquid plus fund that do not have exit load than to invest in a short term bond fund with an exit load of 0.5% if you were to exit before six months from the date of allotment of units.

Source: Economic Times