How to earn higher returns than FDs?

Financial experts are known to repeat the axiom that death and taxes are inevitable in life. But they forget to add one more item to the list: contingency funds. Due to the uncertainties that govern our life, we don’t have an option but to maintain a corpus to meet emergencies. The golden rule, most wizards maintain, is to maintain emergency funds to match at least four months’ expenses.

Such money in most cases is kept in savings accounts or invested in liquid funds or fixed deposits of very short term, say 30-91 days. The idea here is to earn some returns without compromising liquidity.

What are bond funds?:

Short-term bond funds and ultra short-term funds (also known as liquid-plus funds) have emerged as preferred vehicles for investors to ride out rising interest rates. Short-term bond funds are mutual fund schemes that invest in bonds and other fixed-income instruments that have a tenure of around one year. The fund manager builds a diversified portfolio of fixed-income instruments with varying maturities. The portfolio comprises treasury bills, certificate of deposits, commercial papers, securitised debt and advances in the call money market.

The ultra short-term fund focuses on very short-term instruments in the fixed-income space. It invests most of the money in call money and other shortterm instruments, offering good liquidity (for a listing of these funds see table). The Reserve Bank of India (RBI) has increased the repo rate (the rate at which it lends to commercial banks) by 125 basis points in this financial year. This, in turn, pushes up the rate of interest on shortterm borrowings for corporate entities and commercial banks.

What do they do with your money?

These funds invest in financial securities that mature in three months which are currently offering an annualised return of 9%. They also invest in one-year tenure instruments that offer 9.25% returns . Of course, public sector banks have also been hiking interest rates on their fixed deposits. But the returns offered by short-term financial securities are higher than fixed deposits offered by large banks for a similar tenure, which makes the fund route rather attractive.

Let’s take the case of one-year fixed deposit . The interest rate being offered currently by most banks is in the range of 7.5-8 .5% whereas short-term financial securities offer higher returns. Shortterm funds invest in short-term financial securities. So in the days to come it is highly likely that that these funds may give higher returns than those given by fixed deposits.

Why should you invest?:

Also, once an investor invests in a fixed deposit he is locked into it. If the interest rate keeps rising, it will be difficult for him to capture the higher interest rate unless he breaks the current fixed deposit to get into a new fixed deposit. That, of course, has its own issues. But, if the investor invests in ultra short-term funds and short term bonds, he can hope to capture the higher interest rates that may be on offer. These funds invest in different kinds of financial securities which have varying maturity periods.

So, the money coming in from the financial securities that mature can be used to invest in the new financial securities offering a higher rate of interest.

In the recent monetary policy, RBI has left the key rates unaltered. Though the statutory liquidity ratio (SLR) has been reduced to 24% from 25% to accommodate liquidity along with bond buy back, there is no signal from RBI regarding lowering of short-term interest rates. The regulator has not taken any long-term measure to improve liquidity which may bring down the short-term rates.

This is also the season when companies pay advance tax to the government. This means all the idle money that companies have is going to disappear. This, in turn, would mean a further scarcity of money in the market, which would push up interest rates further.

Over and above this, till the end of this financial year — March 31, 2010 — there is a strong line of initial public offerings (IPOs) and follow-on public offerings (FPOs) that are expected to hit the stock market. This will further tighten the money situation, creating more demand than supply, and hence higher interest rates.

Also, to support the increased lending, banks will issue more certificates of deposits on higher interest rates. All these reasons make an even more strong case for investing in short-term and ultra short-term funds.

It makes sense to look at exit loads if any, especially in case of short term bond funds before investing. Funds with low expense ratio spell out better returns.

What about tax?:

An investor looking to invest in these funds with a less than oneyear time-frame in mind should ideally go for the dividend option to ensure better post-tax returns. The dividends declared by liquid-plus and short-term bond funds attract tax at 13.841%. If you opt for the growth option, your gains will be treated as short-term capital gains and taxed according to the income tax bracket you fall into.

So, if you fall in the top tax bracket, you will be taxed at the rate of 30.9%. Mutual funds typically keep declaring dividends on these schemes so as to ensure that investors’ gains are taxed at a lower rate of 13.841%, making the monthly dividend option more attractive for short-term investors.

Also, if you want to invest for a period that exceeds one year, and you happen to choose the growth option, your gains will be taxed at the rate of 10% without indexation or 20% with indexation, which ever is higher. If you invest in a fixed deposit and fall in the top tax bracket, the interest earned will be taxed at 30.9%.

What are the risks?:

But a point to note is that interest rates and prices of financial securities move in opposite directions. So, if interest rates keep going up, the prices of financial securities go down. This is because the newer financial securities offer a higher rate of interest. This, in turn, means that the net asset value of the scheme also goes down, leading to lower returns.

So, it is essential to enter these funds at the right time and stay invested throughout the up-cycle . In case of short-term bond funds, once you get your timing of investment right you should stay invested for at least a year’s time to ride out the investment cycle as well as ensure that your capital gains are taxed at lower tax rates.