What are ultra-short term bond funds?

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By Roshni Agarwal

Updated: Friday, July 19, 2013, 15:32 [IST]

Ultra -short term bond funds are a type of mutual funds that invest in fixed-income securities with comparably shorter maturity term that ranges from few months to a year. Such funds like any other bond funds are provided with options to invest in a gamut of securities such as government securities, corporate debt, asset-backed securities including mortgage-backed securities.

Due to a shorter investment duration, such funds show very less sensitivity to changes in interest rates. As a result, value of such funds is only marginally impacted in comparison to long or medium-term bond funds. Consequently, ultra-short term bond funds, emerge as better investment options for individuals with investment horizon of few months.

Ultra-short term bond funds and Liquid Funds:

Previously, referred to as liquid plus funds, ultra-short term bond funds are riskier investment option in comparison to liquid funds that invest in money market instruments and hence offer comparably higher returns.

Average returns offered by Ultra-short term bond funds:

Ultra-short term bond funds are low risk investment options. Top funds have reportedly offered a return of over 9% in the last one year

Tax implications for holding ultra-short term bond funds :

In case of ultra-short term bond funds, dividend distribution tax @ 28.33% (effective June1, 2013) would be deducted of dividends paid. Further, depending on the time of sale of such funds, investor would have to pay short or long-term capital gain.

Owing to higher dividend distribution tax, post-tax return for investors would decrease. Hence, if an investor has comparably higher investment horizon, he should consider other debt funds.

Risks associated with Ultra-short term bond funds:

Investments in ultra-short term bond funds also pose risk depending on several factors that include :

Credit quality of the securities in which a fund invests:

Despite the implicit safe nature of ultra-short term bond fund investment, such funds may pose risk owing to the downgrade or default of the securities in the fund's portfolio. Generally, credit risk is less of a concern in ultra short term bond funds that invests in government securities. However, funds invested in bonds of companies with lower credit rating increases risk exposure.

Sensitivity to changes in interest rates:

Though, ultra-short term bond funds are viewed to be less sensitive to changes in interest rates, the net asset value (NAV) of such funds do change with increase or decrease in market interest rates. Thus, it is important to consider the "duration" parameter before considering an investment in such funds. This parameter signifies the extent to which the value of the fund would change with % change in interest rate.

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