Bank fixed deposits offer assured returns but are entirely taxable. Ultra short-term debt funds can't specify returns but are tax efficient.

The global economic downturn coupled with stubborn domestic inflation has depressed the stock market for a while now. So, investors have turned to fixed income avenues in a bid to safeguard capital and earn a return that would at least cover inflation. Bank fixed deposits (FDs) have been popular for this. Ultra short-term mutual funds (MFs) have been another favoured option. Besides, this product is more liquid and tax-efficient than FDs.

While it is possible for investors to avail of high interest rates for little or no risk at all, the choice of fund is important. The average one-year return on most income schemes is around 6.5 - 7 per cent.

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This is because existing income schemes are saddled with paper already invested in the past at lower rates. When the rates start climbing, existing low-yield papers are sold at a discount, thereby lowering the Net Asset Value (NAV) and the return on investment.

Interest rates and prices of fixed income instruments share an inverse relationship. In other words, when the overall interest rates in the economy rise, bond prices fall and vice versa. This is called the interest rate risk, and adjusting the portfolio to the market rate of returns is 'marking to market'.

To illustrate, assume the current NAV of the MF is Rs 10 and its corpus is Rs 1,000 crore. Let's say the interest rate rises from eight to ten per cent. Immediately thereafter, you wish to invest Rs 1 lakh in the scheme.

Realise that the entire corpus of the fund stands invested at an average return of eight per cent. If the fund sells the units to you at its current NAV of Rs 10, you will be allotted 10,000 units. This will not be a good deal for you. The return on your money that will be invested at 10 per cent will be shared by all other investors, too.

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This is unfair to you. Therefore, something has got to be done by the fund to protect your interest. Here comes the 'mark to market' concept. In simple terms, the fund lowers its NAV to Rs 8. You will be allotted 12,500 units and not 10,000. The return on 12,500 units at an NAV of Rs 8 would be the same as that of 10,000 units at Rs 10.

In other words, interest rates and prices of fixed income instruments move in opposite directions -- the NAV falls when the interest rates rise and vice versa. Or when interest rates rise, the value of long-term debt gets diluted.

There are two ways to get out of this trap. Possibly, by holding the investments till maturity. Interest rate risk only comes into play when a transaction is undertaken during the currency of the fixed income instrument. Ergo, it follows that if the investment is held till maturity, there would be no interest rate risk.

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Which is why, for investments such as FDs, relief bonds etc, there is no interest rate risk, as these investments are normally held till maturity. Fixed Maturity Plans (FMPs) are another example where the MFs invest in underlying securities where the balance maturity period is the same as the tenure of the FMP, thereby eliminating the interest rate risk.

The other way out is by investing in the above mentioned ultra short-term plans of MFs, where there is minimum fluctuation in interest rates and hence, little or no interest rate risk.

These funds invest in debt paper having a short maturity, generally between 6 - 18 months. This covers instruments such as commercial paper, certificates of deposit, other money market instruments and bonds with short maturity.

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These funds score over the FDs on the risk-return, liquidity and tax efficiency parameters. The annual FD returns of 9.5 per cent is fully taxable. At a 30 per cent tax rate, the return plummets to 6.65 per cent.

On the other hand, an ultra short-term fund, being a non-equity scheme, tax at 10 per cent would be applicable across slabs. This tax arbitrage jacks up the effective rate of the instrument and, hence, the MF plan scores FDs.

The only major concern investors could have is that the category average returns of ultra short-term funds over the past year have been around 8.5 per cent, lower than those from FDs. However, comparing the historical return of one instrument against the future return of another is incorrect and can lead to sub-optimal decision making.

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In other words, an FD and an ultra short-term fund may be similar in substance but they differ in form. FDs specify the rate offered for the future. However, MFs aren't allowed to guarantee or specify returns. Instead, investors would get the return that the underlying portfolio earns after expenses.

Here, the investors try to gauge the fund's worth based on past performance. But, this may be an effective tool to compare equity-oriented funds. For debt funds, in a constant and dynamic interest rate scenario, it would throw up an erroneous conclusion.

Interest rates seem to have peaked and going ahead, yields should stabilise. The Reserve Bank of India is not expected to carry out further rate hikes, as it can adversely affect growth. Therefore, if you're looking to diversify your portfolio by adding a dollop of debt investments, ultra short-term income funds could be a wise choice.

The writer is Director, Wonderland Consultants.