Economists unite in the opinion that the inflation rate is unlikely to taper down any time till the end of the year. As long as inflation is out of the comfort zone, policy measures to curb liquidity would continue, which means interest rates are likely to tread northwards, which rings in good opportunity for investors of short-term debt funds.

Investors have been going through testing times over the past few months – a volatile stock market alongside a spiralling inflation gobbling up their investment returns. Inflation rate peaked up to a 16-year high of 12.63 per cent in the week ending 9^th August 2008. The RBI, on the other hand, has been struggling to rein in the runaway inflation – the repo lending rate hiked to a 7-year high of 9 per cent in July 2008 and the Cash Reserve ratio (CRR) was raised from 8.75 to 9 per cent. While the stock markets have reacted negatively to this, the question lurks whether debt funds could do the magic?

The present scenario of stock market slump has opened up good opportunities for investment in debt instruments. However, thanks to inflation, yields on most of the debt instruments, like fixed deposits, are negative. The average return of 8-9 per cent on bank fixed deposits is way below the current inflation rate, rendering them unattractive. Moreover, long-term debt funds have also been reeling under pressure. This is because a hike in CRR brings about a rise in interest rates. As a result, banks and institutions raise coupon rates on their debt offerings, owing to which investors who had invested in debt securities prior to the hike experience a fall in the net investment value while fresh investors get an opportunity to earn higher coupon rates. Besides, the Net Asset Value (NAV) of debt funds depreciates with the rising interest rates, the proportion of which is higher in case of long-term debt funds.

Thus, in the present situation of rising interest rates, it would be advisable to park funds in short-term debt funds as it would give you more liquidity and render a chance to earn higher returns should the interest rates climb further.

‘Short’ in the arm

While medium and long-term debt schemes have posted negative returns over the past six months, short-term debt funds, such as Liquid Funds and Fixed Maturity Plans (FMPs) have been amongst the best performers during the same period. There are a number of short duration debt schemes in which one can invest.

Liquid funds, which invest in money market instruments and call money, are ideal for investors with a very short investment horizon, say a day. Liquid plus funds invest in overnight instruments, commercial paper and certificate of deposits, and have a higher maturity and duration profile as compared to liquid funds. While liquid funds score high on liquidity, access to current yields and carry low interest rate risks, they are unable to acquire higher yields available on longer maturity periods. On the other hand, while other short-term plans of longer duration gain on this aspect, they carry low liquidity and NAV stability. A Liquid Plus fund attempts to fill this gap by investing a larger chunk in traditional liquid fund assets and the remaining in longer maturity papers. Thus, a combination of liquid and liquid plus funds can help in optimizing returns without giving up on liquidity.


Floating rate funds
These funds invest in debt instruments having coupon rates linked to a benchmark, for instance Mumbai Interbank Offered Rate (MIBOR). The coupon rate on the debt instrument is varied according to the changes in the benchmark rate. A floating rate debt instrument better reflects the changes in interest rates as against their conventional counterparts (fixed rate). These funds invest largely in securities with floating rates and as coupon rates are revised periodically, they carry low interest rate risks. Floating rate funds of short duration are a safe bet in the present scenario of high interest rates, as they are better equipped to deal with such fluctuations, thus reaping higher yields on your investment.

Fixed Maturity Plans
These are similar to bank fixed deposits and invest in debt securities having same maturity period as the fund. As such they are least affected by interest rate fluctuations. However, one should consider the default risk before investing.

 
Monthly Income Plans (MIPs)
MIPs invest predominantly in corporate bonds but also devote a portion of the portfolio to cash and government securities to gain on the changes in interest rates. In addition, they have a small exposure to equity (around 25 per cent) which assures steady returns while preserving capital.