When interest rate hikes are round the corner, investors are exploring various investment options to earn fixed interest. Among several short duration investment options, they can explore short duration target mutual funds or bank fixed deposits (FDs).
When interest rates increase, long term bond yields tend to rise and their net asset value decreases. Those investors with a 1-to-3-year horizon can contemplate investing in shorter-tenure bank FDs as of now and later to reinvest at better rates later.
Debt funds
As a matter of fact, shorter-duration debt funds may be seen as an alternative to bank deposits, but these are subject to interest rate risk. This means fall in bond prices, and consequently the NAV, as interest rates rise, just like longer-duration funds, although to a lesser degree.
And if you redeem your investment in a debt fund before three years expire, your return will attract income tax at your slab rate just like an interest income from fixed deposits.
One may say that debt funds are more liquid as compared to bank fixed deposits since you can exit your investment any time. But since interest rates are expected to go up, an early exit in short duration debt funds can expose you to interest rate risk.
Returns from debt funds with a duration of less than one year, though typically less volatile, may not be very different from those of comparable bank fixed deposits. Ultra-short and low duration funds currently show a yield to maturity, a rough return indicator, of 4-4.5 per cent. Also, while a premature exit from a bank FD may entail a penal rate of interest, it is known, unlike the uncertainty of how interest rate risk will play out in a debt fund.
Target mutual funds
Just as debt funds, target maturity funds (TMFs) are also exposed to interest rate risk, which means, a mark-down in NAVs when bond yields spike. Investors can minimise this risk by staying invested until maturity.
Target mutual funds (TMFs) are debt funds with a defined maturity which invest passively in the bonds of a particular index. In case you stay invested till maturity, your return will be the yield-to-maturity (YTM) after excluding only the expense ratio.
If you redeem prematurely, you face the prospect of capital loss impacting your fund returns. Those investors with moderate risk appetite, and a time horizon of three years or longer can choose TMFs with exposure to State government bonds or SDLs which offer better yields than Government bonds.
“You can park some money in target mutual funds if the fund maturity matches your investment horizon. This will be a better deal than bank FDs,: says Deepak Aggarwal, a Delhi-based financial advisor.