Avoid short-term debt funds

Last Updated: Wed, Feb 13, 2013 07:10 hrs

Last year, if you wanted to invest for the short term, say up to six months, you could have blindly chosen a fixed maturity plan (FMP) or a liquid debt fund from any of the fund houses. The high interest rate scenario made these products extremely attractive.

But since interest rates have started falling there aren't too many FMPs being launched for three and six months duration, this year, unlike last year, says Hemant Rustagi, chief executive officer of Wiseinvest Adivsors.

"An FMP now makes sense only if your investment horizon is more than one year. And if you invest for 15-18 months, now, you will get the benefit of double indexation, since it is spread over two financial years," Rustagi adds.

At this juncture, given that the first rate cut has come and more are expected, one should stay invested in longer duration bond funds, says Sandeep Singhal of Emkay Global Financial Services. For instance, if the yield on the bond is eight per cent and the duration of the fund is seven years, and assuming interest rates come down even by one per cent, it means a corresponding increase in the yield every year. This translates into eight per cent plus seven per cent (one per cent for each of the seven years), that is, 15 per cent return.

Since the market always discounts a rate cut in advance, an investment of a sharp six to eight months horizon may not be the best option. It is better to look at an investment horizon of at least one year to take advantage of the interest rates movement, Singhal points out.

Debt instruments invest in money market instruments of corresponding duration, such as commercial paper (CP) or certificates of deposit (CD). And the interest rates on these instruments have been falling over the last year. According to data from Bloomberg, in April 2012, the return on a three-month CP was as high as 10.75 per cent, whereas now it is 9.41 per cent. Similarly, for a six-month CP, the rate has fallen from 10.6 per cent in April 2012, to 9.47 per cent now. The rate on the three-month CP had fallen to 8.61 per cent as on January-end and that on the six-month CP to as low as 8.96 per cent.

Interest rates are seasonal and tend to rise towards the end of the year, due to liquidity crunch. Even so, instead of investing for a very short term such as six to eight months, it is better to invest in debt funds with at least one to two years maturity, as these will let you play the interest rate game better, says Raghvendra Nath, managing director, Ladderup Wealth Management.

"One can look at short term debt funds because they have low volatility and try to play on the lower end of the yield curve. So, if interest rates do go up, the impact on the overall portfolio will not be much. And if interest rates go down, you will get an extra one-two per cent return," he says.

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