Invest in Debt Funds when Rates are high
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Product Snapshot
Investors in FMPs have to trade off between a fairly predictable return in line with the prevailing market yields and the liquidity and credit risk factor. While the credit risk is managed through investments in higher-rated securities, investors have to seek liquidity through the exchanges where the schemes are listed.
The dividend income is taxed at a DDT equal to that of debt schemes for retail investors. 

Short Term Income Funds
The current rates in the money market continue to provide attractive returns to retail investors in accrual-based products. However, in the prevailing scenario, retail investors could look at a combination of products to exploit the interestrate cycle and to generate optimal risk-adjusted returns.

For retail investors with moderate risk appetite and seeking liquidity, short-term funds with a tenure of at least six months would be the best option for investments.

Short-term income funds generate returns through a combination of accrual income and capital gains on the invested portfolio.
In response to higher inflation, the RBI has increased policy rates by more than 250 bps since March 2010. Tight liquidity and monetary tightening have started to impact the real economy with early signs of growth moderation.

Going forward, it is anticipated that the RBI is closer to the end of the tightening cycle. In such a scenario, the maturing amounts in FMPs/FDs, etc, would carry higher reinvestment risks.

In the current scenario, high money-market rates in the short term are also accompanied by attractive spreads in the AAA segment in the 1- to 3-year corporate curve.

Short-term income funds have an investment mandate to exploit the above opportunities. Retail investors can consider these funds as they have the potential to provide higher accrual income and also the flexibility to generate capital gains when the market yields move down and also via spread compression. These schemes typically maintain a portfolio average maturity of around 2-3 years. Hence, these schemes are exposed to lesser interest-rate risk and would appeal to investors even in the current interest rate cycle.

In short, debt schemes provide investors options for primarily generating income via accrual to a combination of accrual income and capital gains. The relative allocations among these categories should ultimately be a function of the overall asset allocation and risk tolerance.
Debt mutual funds provide retail investors an avenue to diversify their investments while also providing tax-efficient returns better than traditional investment avenues. The investments in various debt mutual funds can be taken both as part of a normal asset-allocation process or even on a tactical basis.

With the current volatility in the capital markets, investors can use debt funds to even temporarily park their investments and switch to equity-oriented funds in a systematic basis.

In the current interest rate scenario, retail investors can optimise their overall portfolio by investing in as liquid/ultra short schemes, fixed maturity plans and shortterm income funds. Given the fairly large choices available, an investor should make a decision on the basis of investment objective, risk appetite, and time horizon. 

Liquid/Ultra Short Schemes
Liquid schemes invest in very short-term money market securities maturing within 91 days. Ultra short-term schemes are moneymarket schemes where a majority of the investments are made in the three months bucket.

Ultra short schemes take marginal exposure to securities beyond three-month tenure to generate higher yields.
Both these categories of products offer high liquidity. The returns from these funds are a function of the prevailing money-market scenario and typically provide higher returns during a high inflation/ tight liquidity scenario like the one being witnessed now. Investors in these funds are exposed to lower interest-rate risk.

The credit risk in these funds is also sought to be addressed by investment in securities with the highest credit ratings.
The dividend-distribution tax (DDT) for retail investors is 25% (plus 5% surcharge and 3% cess) in liquid schemes whereas ultra shortterm funds, falling in the category of income funds, have a DDT of 12.5% (plus 5% surcharge and 3% cess).

Liquid funds are ideal for investors with a very short-term horizon ranging from overnight to a few days and with a limited risk appetite, and who desire a stable accrual income. Ultra short-term funds are suitable for an investment horizon ranging from a week to a month. Both liquid and ultra short-term schemes are an alternative investment avenue for retail individuals to park their short-term surpluses in a tax-efficient manner.

Investors should ideally spread their short-term cash surpluses among various avenues such as liquid funds, ultra short-term funds and bank savings accounts to optimise returns and also provide liquidity for daily transactional needs.

Retail investors with an investment preference for equity products can also use liquid/ultra short-term funds for temporarily parking the surplus before deploying them in the equity markets.

Fixed Maturity Plans
Fixed maturity plans (FMPs) invest in securities matching the scheme tenure so as to lock in the yield prevailing at that time. These schemes have been popular of late due to the high interest rate scenario. Based on the current market yields, FMPs, especially in the oneyear bucket, remain attractive for debt-based investments for investors who do not have liquidity considerations.
(Updated - 26 Nov 2011)

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