Stay short, or go for fixed maturity plans

With interest rates likely to go up in the future, staying with liquid or liquid-plus funds will mean better returns and flexibility.

Today, when the Reserve Bank of India (RBI) raised key rates — repo and reverse repo — by 25 basis points, debt fund investors would have wondered if this was the time to get locked into medium or long-term schemes. The answer, however, is still no.

Financial experts feel with inflation still not under control, the apex bank could raise rates in the future. As Amandeep Chopra, head, fixed income, UTI AMC puts it, “It is advisable to go for liquid and liquid-plus or ultra short-term schemes because more rate rise is likely in the future ,” he added.

Staying short will also mean provide flexibility, in terms of moving money from one kind of scheme to another, if there is a change in the interest rate cycle. Also, short-term debt funds will give better returns because the constant churn that fund managers have to do.
 

DEBT FUND OPTIONS

• Liquid funds: These are schemes where investments can be made for up to 90 days. They invest mostly in money market instruments. 
• 1-month =0.6, 3-month = 1.87, 6-month - 6.50 
• Ultra short-term funds: Earlier, known as liquid-plus funds (locked in for a couple of days) they give better, tax-efficient returns. They invest in debt and money market instruments with a maturity of 90 days to one year. 
• Returns (%): 1-month = 0.65; 3-month = 1.95; 6-month = 3.50 
• Short-term bond funds: Relatively safer and provide stable returns along with protecting your capital. They park money in debt and money market instruments for 1-2 years. 
• Returns (%): 1-month = 0.65; 3-month = 1.80; 6-month = 2.83; 1-year = 5.25 
• Medium-term debt funds: These funds are more volatile as their portfolios have instruments with longer maturity duration. They invest in corporate bonds, debentures, govt securities and money market instruments with maturities of two years. Investments in corporate bonds make them a little risky. 
• Returns (%): 1-year = 5.63; 2-year = 3.76 
• Gilt funds: Best for those who seek safety with liquidity. The prices of gilts fluctuate sharply, as they are highly sensitive to interest rates. They primarily invest in government securities, which don't carry risk of default and interest payment is assured. 
• Returns (%): 1-year = 5.58
• Fixed maturity plans: The tenure can range from 1 month to 2-3 years. They invest in both corporate papers and government securities. 
• Returns (%): 3-month = 9.55%, I year = 9.9 %

According to Value Research, a mutual fund research agency, ultra short and liquid debt funds have returned 6.09 per cent and 6.02 per cent annually. While gilt, medium and long-term debt funds gave 5.63 per cent. This clearly indicates that short-term funds were able to stay ahead from longer-term funds, in terms of returns.

However, there is a word of caution. If one were to move their money too much in one year, there would be a tax on short-term capital gains. The capital gains will be added to your income and taxed, according to the income tax slab.

Another reason why fund managers are advising against locking-in money in medium or long-term debt schemes is because of the inability to take advantage of any rise in the rates in the future. Also, rise in yields will impact returns of long-term funds adversely because of the inverse relationship with price of bonds .

Mahendra Jajoo, executive director and chief investment officer, fixed income at Pramerica Mutual Fund feels by June, when early indications are available for monsoon, a clear trend on long-term rates will emerge.

However, if you want to lock-in money in existing rates, look at fixed maturity plans (FMPs). FMPs are offering 9.9 per cent to 10 per cent for a one-year term. And despite being riskier than other debt schemes because of their exposure to corporate paper, these schemes get double indexation benefits for tenures that are slightly more than one year.

Say, if one invests in an FMP in March 2011 which is maturing in say, May 2012, there will inflation indexation benefits for years 2010-11 and 2012-13. This would mean higher post-tax returns for the investor.