"Currently, investments in short-term debt funds are lucrative as the interest rates on short-term government issues are higher than long-term rates," says Yadnesh Chavan, fund manager, fixed income, Mirae Asset Global Investments. According to Bloomberg, the spread between 10-year (8.2%) and one-year (8.17%) gilt papers shrunk to around .03% on 10 August against a 1.41% difference a year ago. This is due to the steady increase in prime lending rates by the RBI (11 times in the past 16 months) and the resulting tight liquidity as well as strained government finances.
BETTER THAN FDS:
If you want to invest for periods ranging from one month to two years, short-term mutual funds are a better investment choice than bank fixed deposits (FDs). "Usually, FDs don't offer a very high return for a short tenure. Top funds, on the other hand, can give returns of 8-9% a year for a short period of 1-6 months," says Ashwinder Singh, head, wealth management, Fullerton Securities & Wealth Advisors. The funds provide better returns as they can churn their portfolios and invest in different types of financial securities that have varying maturity periods.
Such funds are also more liquid as their exit load is usually nil or lower than the penalty imposed on premature withdrawal for FDs, which is 1-2%. Besides, short-term mutual funds are also more tax-efficient than FDs, at least till the Direct Taxes Code (DTC) comes into effect from 1 April 2012. While proceeds from FDs are added to one's salary and taxed according to the income tax slabs, in the growth option of debt funds, only short-term capital gains are taxed as per the tax slab. Long-term capital gains are taxed either at 10% (with indexation) or 20% (without indexation). "The dividend option yields even better returns," says Jayant Pai, vice-president, Parag Parikh Financial Advisory Services.
However, if you invest in a mutual fund now, it will probably mature after 1 April 2012. Under the DTC, there will be no distinction between long-term and short-term capital gains of non-equity mutual funds. The capital gain will be added to the income of the investor and taxed according to the applicable tax slabs.
HOW TO SELECT A FUND
While choosing a fund, the most important factor you must look for is the credit rating of the debt instruments in which these funds are parking their corpus. This is even more important in case of fund types that have a relatively long-term focus as these tend to invest in instruments which are more risky. Another fundamental to be considered is the expense ratio of the fund, which should be below the category average.
"The nominal returns from such funds are usually in single digits, so any saving on the expense front is welcome," says Pai. Financial advisers also recommend choosing a scheme where the assets under management are in line with or higher than the category average. "It will ensure that sudden redemptions don't have a huge impact on the cost of the scheme," says Pai.
Investors must also take into account the interest rate risks of the fund. The interest rate risk of a bond portfolio largely depends on the maturity profile of the fund. The longer the maturity, the higher is the rate risk. The overall interest rate environment is a good guidance to the way bond prices will move. "If interest rates are expected to go up, it's better to invest in funds with the shortest maturity tenure," says Chavan.
TYPES OF FUNDS
Here's a look at the different types of short-term funds that you can pick depending on your investment horizon and risk profile.
Liquid funds:
Investors with a time horizon of 3-6 months can consider liquid funds as these invest in debt instruments with a maximum maturity of 91 days. "The funds are also good to initiate systematic transfer plans as the exit loads are usually nil," says Pai. So, liquid funds can be used to deal with equity market volatility and augment one's returns.
These funds can provide you with better returns compared with those from savings account and also offer the benefit of averaging. They have low interest rate and credit risk as the funds invest in securities with shorter maturity periods that are highly rated.
Ultra short-term funds:
Ultra short-term funds give higher returns and are more risky compared with liquid funds as they invest in instruments with longer maturity periods. They also have an advantage over liquid funds due to the differential dividend tax treatment. The dividend declared by an ultra short-term scheme is taxed at 12.87%, while that by a liquid fund is taxed at 25.75%. "In terms of tax benefit, it is definitely better for investors, whose incomes fall in the higher tax slabs, to invest in the dividend option," says Chavan.
Short-term funds:
These funds invest in debt securities with over one year maturity and their interest rate risk is low to moderate, depending on the maturity profile of the fund. Experts recommend these funds for an investment horizon of 18 months or up to two years. Exiting the fund at an early stage may lead to losses as these impose loads for longer periods. Such funds also choose debt instruments that have a maturity of less than a year, but financial advisers warn against such schemes. "If a fund is overweight in such short-term instruments, its average residual maturity falls below one year and the purpose of investing in a short-term fund is defeated," says Pai.
Income funds:
These are good for investors who want regular and steady income. "They help to diversify your portfolio and modulate the ups and downs of equity investments," says Singh. Income funds offer relatively high returns compared to the above three categories but are also prone to higher interest rate risk. "Invest in these funds if your horizon is beyond two years as it will help in moderating the volatility," says Pai. "These funds provide superior returns when the interest rate cycle reverses and the rates start coming down," says Chavan.
Gilt short-term funds:
These funds invest in different medium- and long-term government securities. "These are most suitable for people who want to invest in safe instruments that have zero default risk," says Singh. "Their net asset values (NAVs) rise sharply (double-digit returns are common) in a falling rate regime," says Pai. However, capital loss can occur in a rising rate regime as bond prices share an inverse relationship with interest rates and these funds usually have one of the highest residual maturities. "These funds deliver flat to negative NAV returns in a rising interest rate environment," says Chavan.
http://articles.economictimes.indiatimes.com/2011-08-29/news/29941456_1_debt-funds-mutual-funds-mirae-asset-global-investments/3
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