Invest in short-term funds to combat interest rate hikes

Investment

oi-Monika Nihalani

By Monika Nihalani

Published: Monday, June 6, 2011, 14:37 [IST]

Reserve Bank of India is continuously revising monetary policy and raising short-term rates. As long as inflation is out of the comfort zone, policy measures to curb inflation would continue, which means interest rates are likely to tread up.

High interest rate opens up many doors for short-term fixed income investors. Recent repo rate hike i.e. by 50 basis points by RBI in turn have increased the rate of interest on fixed deposits. It is quite possible that the short-term rates may go up again in near term which provides investors number of short-term alternatives to invest in for e.g. Fixed Deposits, Fixed Maturity Plans, Short-term Bond Funds and Floating Rate Funds.

Fixed Deposits
Bank fixed deposits provide fair return if you are looking for short-term investment.

But that's not good option for High Net-worth Individuals (HNIs) because this category of investors fall under the highest slab and tax applicable for them is 30.9%; so effective return for them will be lower.

Investors who fall under low income group and senior citizens with low income can go for nationalised banks fixed deposits. Pre-tax return provided by bank on fixed deposits is around 7% to 9% for tenures between 3 months to 12 months. And, investing with some nationalised bank comes with sovereign guarantee.

There are also six-monthly, company fixed deposits but it always entail higher risk for investors if company is not rated.

Fixed Maturity Plans (FMPs)
Fixed Maturity Plan is another good option during sky-rocketing interest rates. It provides fair return to investors who want to park their money for short span. Especially High Net-worth Individuals can reap the benefit from FMPs as post-tax return will be relatively higher than return on Fixed Deposits.

FMPs are basically close-ended debt funds that invest in debt and money market instruments for short period. They come with different maturities such as monthly, quarterly, half-yearly, annually and even plans with maturity of more than 1 year. The scheme does not take interest rate risk.

If you are choosing FMP of less than one year, you can go for the dividend option. Dividend provided under these schemes attract a dividend distribution tax of 13.52%, that makes post-tax returns attractive compared to interests received on fixed deposits, which are taxed at 30.9% for those who come under high-tax slab.

Short-term liquid funds
Short-term liquid funds which invest in money market instruments and call money market, are ideal for people with short investment horizon. These funds score high on liquidity and carry minimum interest rate risks.

Floating Rate Funds
Floating Rate Funds are also an investment option that invest in debt instruments having coupon rates linked to a benchmark, for example Mumbai Interbank Offered Rate (MIBOR). The coupon rate on the debt instrument is calculated on the basis of the benchmark rate. These funds reflect changes in interest rates as against the conventional fixed rate notes which do not reflect change in interest rates.

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