Beat inflation with ultra short-term income funds

If you are looking to diversify your portfolio by adding a dollop of debt investments, ultra short-term income funds could be a wise choice at this time.

A prolonged stock market depression following the global economic downturn, coupled with stubborn domestic inflation, has seen investors moving to fixed-income instruments in an attempt to preserve capital and earn returns that are higher than inflation. One option in fixed income instruments is bank fixed deposits which are very popular. However, another avenue that has the potential of delivering possibly higher returns is ultra short-term mutual fund schemes.

This product is more liquid and tax efficient than its fixed deposit counterpart, but identification of the appropriate type of fund is important for the investor. Lets take a look at some options. For regular income schemes, the average one-year return is only around 6.5% to 7% per annum. This is because existing schemes are saddled with paper already invested in the past at lower rates of interest. When rates start rising, this low-yield paper has to be sold at a discount, thereby lowering the net asset value (NAV) and return on investment.

While debt instruments are a good investment option in the current scenario, every investor has to understand the dynamics of these instruments. Interest rates and prices of fixed income instruments share an inverse relationship. In other words, when the overall interest rates in the economy rise, bond prices fall and vice versa. This is called interest rate risk and adjusting the portfolio to the market rate of returns is called 'marking to market'.

To illustrate this, let us assume that the current NAV of a MF is Rs10 and its corpus is Rs1,000 crore. Now assume that the interest rate rises from 8% to 10%, and immediately thereafter you wish to invest Rs1 lakh in the scheme. Understand that the entire corpus of the fund stands invested at an average return of 8%. If the fund sells the units to you at its current NAV of Rs10, you will be allotted 10,000 units. This will not be a good deal for you. The return on your money that will be invested at 10% will be shared by all other investors too, which would be unfair.

Therefore, something has got to be done by the fund to protect your interest. Here's where the 'mark to market' concept comes in. In simple terms, the fund lowers its NAV to Rs8. You will be allotted 12,500 units and not 10,000. The return on 12,500 units at an NAV of Rs8 would be the same as that of 10,000 units at Rs10. In other words, interest rates and prices of fixed income instruments move in opposite directions - the NAV falls when the interest rates rise and vice versa. Or when interest rates rise, the value of long-term debt gets diluted.

There are two ways to avoid this trap. The first is by holding investments till maturity, as interest rate risk only comes into play when a transaction is undertaken. The other is to avoid investing in long-term debt schemes. Here is where the above mentioned ultra short-term plans of mutual funds come in as there is minimum fluctuation in interest rates, as these funds invest in debt paper having a short maturity of generally six to 18  months.

This covers instruments such commercial paper (CPs), certificates of deposit (CDs), other money market instruments and bonds with short outstanding maturity. These funds score over the bank FDs on the risk-return, liquidity and tax efficiency parameters. While a bank deposit nowadays earns interest of around 9.50% pa, this is fully taxable. At a 30% tax rate, the return plummets to 6.65%. On the other hand, for an ultra short-term fund, being a non-equity scheme, tax @10% would be applicable across all tax slabs.

This tax arbitrage jacks up the effective rate of the instrument and hence, the mutual fund plan scores above a bank fixed deposit. The only major concern that an investor could have is that the return of ultra short-term funds over the past one year as a category average has been around 8.5% pa which is significantly lower than returns from a bank FD. However, comparing the historical return of one instrument against the future return of another is not correct and leads to sub-optimal decision making.In other words, though a bank FD and an ultra short-term fund are similar in substance, they differ in form. A bank FD specifies the rate that's on offer for the future.

However, mutual funds don't guarantee or specify returns. The investor would get returns that the underlying portfolio earns post expenses. In these circumstances, typically investors try to gauge how good a fund is based on the past performance. While past performance may be an effective tool to compare equity oriented funds, for a debt fund, in an uncertain yet dynamic interest rate scenario as exists currently, it would throw up an erroneous conclusion.

By the time you read this, the latest inflation figures would have been released and in all probability should be softer than before. Also, a sharp fall in industrial production (5.1% in the month of October), exports being overstated by almost $9 billion, slowing growth and a burgeoning fiscal deficit are some of the macroeconomic indicators that could prevent the Reserve Bank of India (RBI) from carrying out any further rate hikes in its mid-term policy review to be announced on Friday. The only reason that may make RBI pause and not actually ease liquidity is perhaps rupee depreciation. However, one just can't help but feel that in all probability, interest rates seem to have peaked and going ahead, yields should stabilise.

The writer is director, Wonderland Consultants, a tax and financial planning firm. He can be contacted at sandeep.shanbhag@gmail.com