Should You Go for Short-term Bond Funds as FD Rates Fall?

Ultra short-term funds score if you need money in 2-6 mths, but bond funds are in a sweet spot now, says Nikhil Walavalkar

    Even as investors wait to see strong cues on the interest rates movement, banks have already slashed interest rates on fixed deposits by 0.25% to 0.75%. Short term rates — represented by the interest rate on certificate of deposits or CDs — are sliding. Interest rate on three-month CDs was 8.4% on September 28, compared with 10.17% on March 30. One-year CDs quoted at 8.98% on September 28, down from 10.15% on March 30. And many money market analysts believe that the rates will start easing even further if the Reserve Bank of India cut policy rates. “We expect RBI to cut policy rates by 50 basis points in this financial year,” says Pankaj Jain, senior fund manager at Principal Mutual Fund. No wonder, many debt investors are totally clueless about what to do. They simply can’t make up their mind whether they should go for short term bond funds or fixed maturity plans or bank fixed deposits. 

WHAT IS YOUR INVESTMENT HORIZON? “Investors looking to park their money for two to six months should consider ultrashort term bond funds,” says Pankaj Jain. Typically, these funds invest in certificate of deposits, commercial papers and other instruments maturing in and around three months. The primary objective of these schemes is safety and liquidity, and returns come in later. Given the attractive yields on three-month instruments, these funds score better than comparable fixed deposits. One can look at schemes that invest in instruments with high credit rating – typically “AAA”. This ensures safety of capital. Ultrashort term bond funds can be better vehicles to park money for couple of reasons. First these schemes invest in papers with maturities of around three months. This ensures that there is not much impact of changes in interest rates, which means not much volatility in returns. Investors can sit peacefully if they are invested in a scheme floated by fund houses with good track record. “The second benefit comes in the form of no exit loads for most of these schemes, which score over bank fixed deposits which typically come with penalties on premature withdrawals,” says Nitin Vyakaranam, founder CEO, Arthayantra, a financial planning services provider.
“For a time horizon of 9 to 12 months, we are recommending short term income funds to investors. They can also benefit from a potential fall in the short term yields due to rate cuts and or improved liquidity leading to capital appreciation,” says Pawan Joseph, national sales head (wealth management), Motilal Oswal Securities. 

Short term bond funds are in a sweet spot now. The current accruals on the instruments maturing within one year are attractive. If the rates come down in the meantime, investors may see some capital appreciation in the form of rise in bond prices. The returns offered by these funds are tax efficient compared to bank fixed deposits. Dividends paid out by these funds attract a dividend distribution tax of 13.52%, whereas the interest earned on fixed deposit is added to your total income and taxed at the marginal rate, which for the highest tax bracket stands at 30.6%. 

For a timeframe of two to six months and nine to twelve months, ultra-short term bond funds and short term bond funds look good, respectively. 

While investing for the short term in an open-ended fixed income mutual fund scheme, you cannot ignore your liquidity needs. “Know the exit load of the schemes before investing, especially in case of short term bond funds. After all it eats into your returns,” says Pankaj Jain. For example, if you are keen to invest for six months but if the scheme has an exit load of 0.5% for exits within nine months, your return will go down by the amount of the exit load deducted by the fund house. Lock your investment in FMPs if you are sure that you won’t require the money in one year and you want to lock in your returns. 

You should invest in the growth option if you are investing in one-year FMPs. Longterm capital gains are taxed at 20.6% on gain post indexation or 10.3% on gain without indexation. Many experts are of the opinion that you get to enjoy tax-free returns due to the persistent inflation. Stick to one-year FMPs launched by reputed fund houses. “Better to avoid 90-days FMPs, given not so attractive yields available,” says a wealth manager. “Though bank fixed deposits have seen some fall in interest rates, investors from lower income groups can still invest in them,” the wealth manager adds. 

A fixed deposit with a nationalised bank carries little default risk. But in many cases investors have to pay a penalty on premature withdrawals. If you are not keen to take any risk and sure of your investment timeframe, bank fixed deposits can be considered. 

Source : The Economic Times - 9/10/2012