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FMPs and Short Term Mutual Funds offer better returns for now

   Rising interest rates always pose a challenge to debt investors. They know they can earn more from their bank fixed deposits. But many of them get confused whether to lock-in the money on long tenure deposits or opt for short term ones. As for investors of debt mutual fund schemes, the decision making is even more problematic. For most investors know that a rising interest rate regime is bad news for long duration debt schemes as they tend to lose their value in the short term. Also, they have to include a possible hike of policy rates by the Reserve Bank of India (RBI) to figure out where the rates are headed -- both in the short and long term. In short, the life of fixed income investor is not an easy one.


   Investors should remember that the rates are more or less near their peak. The RBI may go for a 25 or 50 basis point (100 basis points = 1%) hike during the year. That means the pressure on rates is likely to remain for some time," says a financial advisor. "In such a scenario, they should invest their money in fixed deposits of banks and companies, FMPs and short term schemes of Mutual funds.

FIXED DEPOSITS

Bank fixed deposits are always the first stop for many conservative investors. However, since the interest income earned on fixed deposits is taxed at the individual's applicable rate of tax, it is not an attractive option for everyone. Especially, for those in the higher tax bracket. This is because the interest income will be taxed at 30.9% for those in the highest tax slab.


   According to investment experts, fixed deposits with nationalised banks are good investment options for investors coming from low income groups. It is also recommended for senior citizens with low income. Bank fixed deposits can fetch you a pre-tax return of around 7% to 9% for tenures of three months to a year. If you are with a nationalised bank, it also guarantee peace of mind as your deposits are back by sovereign guarantee. So, if you are looking for peace of mind and some returns, you can consider such deposits.


   Investors may also come across six-month company fixed deposits, which offer good yield. However, most experts believe that the companies which are offering 10% per annum on such deposits may be cash strapped and they could prove risky. That is why they are advocating debt mutual funds schemes to conservative investors looking to earn some extra returns.

FIXED MATURITY PLANS (
FMP)

Though banks offer 7% to 8% per annum on a 91-day fixed deposit, they are forced to borrow at over 9% in the money market due to the tight liquidity conditions. In fact, banks offer around 9.4% to 9.75% on a three month certificate of deposit to institutional investors participating in the money market. A one-year certificate of deposit, on the other hand, offers in the range of 9.8% to 10%. The most cost-effective way to invest in a certificate of deposit offering such a high yield is through mutual fund. If you are sure about the tenure you are willing to remain invested in and if you will not need the money midway, you may be better off considering investment in a suitable fixed maturity plan (FMP). FMP is a closed-ended debt scheme investing in fixed income instruments that mature on or before the date of maturity of the scheme. On the date of maturity, the scheme is liquidated and the proceeds are distributed to investors. The scheme does not take any interest rate risk. You may come across FMPs offering tenures of 91 days, 180 days and one year. Though no FMP tells you how much return it will offer, you can get an idea of the yield by looking at the prevailing yields in the market. Even if you forego 50 to 75 basis points towards expense, you are still left with a good return.


   For FMPs of less than one year, it makes sense to opt for the dividend option. The dividend announced by these funds attract a dividend distribution tax of 13.52%, which makes the post-tax returns attractive compared with the interests received on fixed deposits, which are taxed at 30.9% if you are in the highest tax slab.


   The main attraction of FMPs is the greater tax efficiency they offer. On a tax-adjusted basis, the return on an FMP is higher than that of a bank FD. This is because interest on bank FDs is fully taxable whereas the return from FMPs is subject to the the capital gains tax for the growth option. Capital gains made on investing in FMPs for a period of more than one year are taxable at the rate of 10% without indexation or 20% with indexation, whichever is lower. Indexation essentially takes the rate of inflation into account while calculating the cost of acquisition of an asset. This ensures that the capital gain is lower, and hence the lower tax. Also the current inflation in the range of 8-9% will ensure that most of the capital gains are not taxable at all.


   The downside in an FMP is lack of liquidity. The scheme units listed on the stock exchange are not traded, which means investors cannot exit till the scheme matures, or the exit can be made only at substantial discount to the NAV.


   That is why you should be absolutely sure that you don't need the money for the particular period you are locking it up in an FMP. Otherwise, it would be a case of wasted time and effort.

SHORT-TERM BOND FUNDS

These schemes invest in fixed income instruments of short durations. At the moment, short-term bond funds with less than one year duration are good investment option for investors. That is, if they have a one-year investment horizon. Lower average maturity of these funds ensures that the fund NAV is not hit much when short term interest rates move up.


However, a possible 50 basis points hike of rates by the Reserve Bank of India may queer the pitch for short-term bond fund investors.


Check the average maturity and exit load before you invest in a short-term bond fund. As a rule of thumb, the average maturity should be less than your investment time frame. Mostly funds charge an exit load if you get out early. To avoid such a cut, it is better to check how the fund charges the exit load. Funds have a wide range of 'exit loads'. Some charge an exit load if you were to redeem units within 90 days, while there are some that let you go if you are invested for at least one month. So check the scheme details carefully before investing.


   Typically, a short-term bond fund manager prefers to maintain low average maturity. As the short term rates are expected to climb further, the funds are expected to continue with the strategy. As the rates peak later this year, fund managers may choose to increase the average maturity of the fund, thereby further increasing the return potential for you. But as the short-term rates move up on the back of possible rate hikes by the RBI in the near term, the NAV of some of the short-term bond funds may come under pressure. If you want to wait till the next rate hike by the RBI, it is better to stay invested in a liquid or an ultra short-term bond funds. These funds are best positioned to benefit from the rising interest rates. This will ensure that the idle funds earn good returns in the meantime.

 

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Also, know how to buy mutual funds online:

 

1) DSP BlackRock Mutual Funds:

http://prajnacapital.blogspot.com/2011/05/buying-dsp-blackrock-mutual-funds.html

 

2) Reliance Mutual Funds:

http://prajnacapital.blogspot.com/2011/06/buying-reliance-mutual-funds-online.html

 

3) Reliance Mutual Funds:

http://prajnacapital.blogspot.com/2011/07/buying-hdfc-mutual-funds-online.html

 

4) Sundaram Mutual Funds:

http://prajnacapital.blogspot.com/2011/07/buying-sundaram-mutual-funds-online.html

 

5) Birla Sunlife Mutual Funds:

http://prajnacapital.blogspot.com/2011/06/buying-birla-sunlife-mutual-funds.html

 

6) UTI Mutual Funds:

http://prajnacapital.blogspot.com/2011/06/buying-uti-mutual-funds-online.html

  

7) SBI Mutual Funds:

http://prajnacapital.blogspot.com/2011/06/buying-sbi-mutual-funds-online.html

 

8) Edelweiss Mutual Funds:

http://prajnacapital.blogspot.com/2011/06/buying-edelweiss-mutual-funds-online.html

 

9) IDFC Mutual Funds:

http://prajnacapital.blogspot.com/2011/06/buying-idfc-mutual-funds-online.html

 

 

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