Short Duration Fund: How SEBI’s 1-3 Year Duration Band Shapes Risk

Ask a debt fund distributor what to suggest for money you’ll need in two years and there’s a good chance the answer is a short duration fund. It sits in a sensible middle spot. The portfolio is long enough to earn more than a liquid or money market fund usually does, yet short enough that a jump in bond yields dents the NAV rather than flattening it. SEBI’s rules decide where that middle spot is, and once you know them you can read any short duration fund’s factsheet in about two minutes.

We’ll go through what the rulebook actually says, how the Potential Risk Class tag works for this category, and a worked example that turns duration into rupees.

What SEBI’s rules say about a short duration fund

The debt fund categories are laid out in Part IV of Chapter 3 of the SEBI Master Circular for Mutual Funds dated March 20, 2026, which lists 17 of them. Item 6 in that table carries the name “Short Term Fund”. The circular’s own risk-class section uses a different label, “Short Duration Fund”, in its worked example. Same category, two names, and we’ll stick with the more familiar “short duration fund” here.

The scheme characteristic is a single condition. The fund invests in debt and money market instruments such that the Macaulay duration of the portfolio is between 1 year and 3 years. Its uniform description, which every scheme in the category has to carry, describes it as an open-ended short term debt scheme investing in instruments such that the Macaulay duration of the portfolio is between 1 year and 3 years.

Notice what the rule does not say. There’s no minimum share in government securities, no rating floor written into the category itself, and no cap on any one instrument’s maturity at this level. The only thing pinned down is the portfolio’s duration. Everything else comes from other parts of the rulebook, which we’ll get to.

The circular also allows only one scheme per category for each fund house, with exceptions for index funds and ETFs tracking different indices, fund of funds with different underlying schemes, and sectoral or thematic funds. So each AMC runs one short duration fund, and comparing across AMCs is a fair like-for-like exercise.

Where it sits on the duration ladder

Duration bands are the backbone of SEBI’s debt categories. Here is how the short-duration band lines up against its neighbours, all taken from the same table in the master circular:

So a short duration fund picks up exactly where the ultra short to short term fund leaves off, and hands over to the medium duration category at three years.

One difference is easy to miss. For the Medium Term and Medium to Long Term funds, the circular lets the manager cut portfolio duration as low as one year if they expect an adverse rate situation, with the reasons recorded and placed before the trustees. The short-term category gets no such clause in that table. Its band is simply 1 to 3 years.

The category rule pins down only one thing: duration. Credit quality, maturity of each paper and liquidity all come from other corners of the rulebook.

What duration actually measures

The Reserve Bank’s FAQ on government securities defines Macaulay duration as a measure of the time taken to recover the initial investment in present value terms, expressed in years. It is always less than or equal to the bond’s remaining life, and only a zero coupon bond has duration equal to its maturity.

The more useful number for an investor is modified duration. The RBI FAQ describes it as the change in a security’s value for a one per cent change in yield, and gives the formula as Macaulay duration divided by (1 + yield/2) for a bond paying semi-annual coupons. Its own illustration takes a Macaulay duration of 1.86 years at a 9% yield and gets a modified duration of 1.78. As the FAQ puts it, duration is roughly the percentage change in price for a one percentage point change in yield.

That’s the whole reason the 1-to-3-year band matters. It caps how much the NAV can swing when yields move. The RBI FAQ also states the basic rule that runs underneath all of this: when market yields rise, bond prices fall, and when yields fall, prices rise.

The Potential Risk Class tag, using this very category

Every debt scheme also has to place itself in a 3 x 3 Potential Risk Class (PRC) matrix, and the master circular happens to use a short duration fund as its worked example, which makes life easy for us.

The interest-rate axis is measured by the portfolio’s weighted average Macaulay duration:

• Class I: Macaulay duration of 1 year or less.
• Class II: Macaulay duration of 3 years or less.
• Class III: any Macaulay duration.

The credit axis uses a weighted average Credit Risk Value (CRV). The circular assigns 13 to G-secs, state development loans, repo on government securities, TREPS and cash, 12 to AAA, 11 to AA+, 10 to AA, and lower numbers down the rating scale, with unrated paper at 2 and below investment grade at 1. Class A means a CRV of 12 or more, Class B means 10 or more, and Class C means below 10.

The circular’s example is a short duration fund that keeps its weighted average Macaulay duration at or below 3 years and its weighted average CRV at 10 or more. That lands it in cell B-II, described as “Moderate Interest Rate Risk and Moderate Credit Risk”. The cell sets the maximum risk the scheme may take. It can always run lower duration or better credit than the cell allows.

Two practical points follow for short duration funds:

• Because the category’s duration runs from 1 to 3 years, these funds will normally sit in the Class II row. So the column, A, B or C, is what tells you the most when comparing two of them.
• A scheme in Class II can hold individual instruments with a residual maturity of up to seven years, according to the circular. Central and state government securities are exempt from that cap. So “short duration” does not mean every paper inside is short.

If you see A-II on a factsheet, the fund has committed to a weighted average CRV of 12 or more, which in the circular’s scale means AAA-equivalent or better on average. B-II allows it to drift down to an AA-equivalent average. C-II means it can go below that.

Liquidity rules that apply here

Paragraph 5.7 of the master circular says all open-ended debt schemes, except overnight, liquid, gilt and 10-year constant maturity gilt funds, must hold at least 10% of net assets in liquid assets. Liquid assets here mean cash, government securities, T-bills and repo on government securities. A short duration fund isn’t on the exempt list, so the 10% cushion applies.

The circular also clarifies that for regulatory limits other than asset allocation limits, including the Macaulay duration calculation, the base is 100% of net assets. In other words, that 10% liquid cushion counts towards the portfolio’s duration like everything else.

One more detail. The circular lets debt schemes invest their residual portion in InvITs, but specifically excludes overnight, liquid, ultra short term, ultra short to short term and money market funds. Short term funds are not on that excluded list, so they may use InvITs within the ceilings in Paragraph 13.13.5. Most investors will never notice this, but it’s worth a look at the portfolio disclosure if you care about what’s inside.

Worked example: what a rate rise costs a short duration fund

All figures below are hypothetical, chosen only to show the arithmetic. They are not the data of any real scheme.

Say a short duration fund reports a portfolio Macaulay duration of 2.2 years and a yield to maturity of 7.0%. Using the RBI’s semi-annual formula:

• Modified duration = 2.2 / (1 + 0.07/2) = 2.2 / 1.035 = about 2.13.
• If yields rise by 0.50 percentage point, the approximate NAV fall is 2.13 x 0.50 = about 1.06%.
• On an investment of Rs 5,00,000, that’s roughly Rs 5,300.

Now set that against the income side. At a 7.0% yield, Rs 5,00,000 accrues about Rs 35,000 a year before costs and tax, or a little under Rs 2,920 a month. So the hypothetical half-point rate shock eats a bit less than two months of accrual. Painful for a quarter, but recoverable within the kind of holding period this category is built for.

Run the same sum for a hypothetical long term fund with a Macaulay duration of 8 years and a 7.2% yield. Modified duration is 8 / 1.036, or about 7.72, and the same 0.50 point rise knocks off roughly 3.86%. On Rs 5,00,000 that’s about Rs 19,300, which is more than six months of that fund’s interest at 7.2% (about Rs 36,000 a year, or Rs 3,000 a month).

These are first-order estimates. The RBI FAQ describes duration as an approximation, and real NAVs also move with credit spreads, portfolio changes and accrued income. But the comparison shows why people park two-to-three-year money here rather than in long-duration funds.

In our hypothetical example, a half-point jump in yields costs a short duration fund under two months of interest. For a long term fund, the same move costs more than six.

Where the real risk hides

Duration is capped by the category. Credit isn’t, at least not by the category definition. That’s why the PRC column matters so much more than the fund’s name. Two short duration funds with the same 2-year duration can carry very different credit profiles: one holding mostly sovereign and AAA paper, the other reaching into AA and lower to squeeze out extra yield.

A few things we’d check on any short duration fund factsheet:

1. PRC cell. A-II, B-II or C-II. That’s the fund’s own stated ceiling on credit risk.
2. Portfolio Macaulay duration. Where it sits inside the 1-3 year band. A fund near 2.8 years will move more than one near 1.3.
3. Yield to maturity versus peers. A noticeably higher yield in the same category usually means lower-rated paper or longer individual maturities, not manager genius.
4. Rating mix. The split between G-secs, AAA and anything below.
5. Expense ratio of the direct plan. In a tightly defined category, costs explain a big chunk of the gap between funds.

If the duration maths still feels abstract, our explainer on bond duration walks through it step by step, and our risk management guide covers how to size any single holding within a wider portfolio.

Who a short duration fund suits

Think of it as money with a date attached, roughly one to three years out. A car down payment, next year’s school fees, a buffer you don’t want sitting in a savings account. The duration band matches that horizon, so a rate shock in the meantime has time to wash out through accrual.

It’s a poorer fit for money you might need next month. That job belongs to liquid, overnight or money market funds, which sit at the very short end of SEBI’s table. It’s also not the place for a big bet on falling rates. If that’s your view, longer-duration categories will respond far more, in both directions.

The bottom line

A short duration fund is defined by one rule: a portfolio Macaulay duration between 1 and 3 years, under the category the SEBI master circular now lists as “Short Term Fund”. That cap keeps rate risk moderate, as our hypothetical example shows, with a half-point yield rise costing about 1% of NAV. What the category doesn’t cap is credit risk, so read the PRC cell and rating mix before the returns column. Pick the fund that matches your horizon and your comfort with credit, not just the one with the highest yield.

Disclaimer: This article is for education only and is not investment advice. Mutual fund investments are subject to market risks; read all scheme-related documents carefully. The worked examples use hypothetical figures. Consult a SEBI-registered adviser before making investment decisions.