Short term fixed income funds invest in a mix of money market securities, government bonds and corporate bonds. Short term funds aim to maintain an overall portfolio maturity of less than five years with portfolio maturities ranging from one and half years to five years. The objective of short term funds is to generate returns through capital gains and interest income with lower interest rate risk. The fall/rise in price of a fixed income security is lower in securities than have shorter maturity dates.
The returns from short term funds are generated from two sources. One source is the interest earned from securities and the second source is capital gains when prices of securities rise. Taking an example.
Short term fund A has a portfolio that has an average maturity of three years and the fund earns interest of 9% from the portfolio. If interest rates fall by 100bps the return on the short term fund after one year will be 11%.
Example 1. Short term fund A with average maturity of three years carrying a portfolio yield of 9%. Returns on the fund if interest rates fall by 100bps is as follows:
Interest earned: 9%
Capital gains: 2%
Total returns: 11% (Interest earned plus capital gains).
The above example is extremely simple in nature as it assumes that the full portfolio will move in tandem with the fall in interest rates. In practice it is not true as a portfolio having a mix of money market securities, government bonds and corporate bonds, is subjected to movements in credit spreads and movements in the yield curve.
The following example will give a better picture of the nature of short term funds.
Short term fund B has a portfolio mix of 20% money market securities, 30% government bonds and 50% corporate bonds. Table 1 shows the portfolio, its average maturity and the yield or the interest earned on the portfolio. The corporate bond exposure is assumed to be in benchmark AAA rated bonds while money market exposure is assumed to be in highest safety money market instruments.
Impact of rise in credit spreads
Short term fund B has a portfolio maturity of 2.8 years and earns 8.7% per year as interest. In theory a 100bps fall in interest rates should generate a return of 8.7% + 1.8% = 10.5%. However if credit spreads rise by 100bps and interest rates fall by 100%, the portfolio returns will be different as 50% of the portfolio, which is invested in corporate bonds will not earn any capital gains. Table 2 shows the return on the portfolio if credit spreads rise by 100bps.
Rise in credit spreads bring down capital gains on the portfolio to 0.9% as against 1.8% if credit spreads remain steady.
Impact of yield curve inversion
Yield curve movement too affect the portfolio returns. If the yield curve becomes inverted, where short term interest rates become higher than long term interest rates, short term funds will suffer. Table 3 shows the impact of yield curve inversion on short term funds.
Yield curve inversion leads to zero capital gains on the portfolio even if interest rates fall at the longer end of the curve.
Credit spreads and yield curve outlook is important when investing in short term funds
Short term funds are not what they seem to be as seen from the examples above. Investors should have a favorable outlook on interest rates, yield curve and credit spreads before investing in such funds. Short term funds that invest in lower rated corporate bonds add on to credit spread risk and liquidity risk. Investors must have an idea of the funds investment objective and marry the objective to the outlook on the fixed income market before investing.
