Got surplus cash? Buy ultra short-term funds

Got surplus cash? Buy ultra short-term funds

If you have idle cash lying around, what do you do with it? Most of us would put it in a bank account and earn a mere 3.5%? On top of it, we would also pay tax on the interest of these deposits at your marginal tax rate, which is 30.99% (including cess) if you are in the highest tax bracket. The logic of taking this low-return route is obviously the low risk involved. However, if you are willing to move away from the familiar comfort of a bank deposit, look at ultra short-term funds that earn you slightly higher returns, save some tax and offer you reasonable amount of safety.

What are these?

Ultra short-term funds, earlier known as liquid plus funds, are close cousins of liquid funds and invest in short-term bonds that mature within a year. Most of them mushroomed in and after 2007 when that year’s Budget increased the dividend distribution tax (DDT)(dividends are taxed at the time they are distributed, thereby lowering your returns) to 28.325%.

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Companies often parked their surplus cash in these funds to get the tax advantage—against 33.99% tax that companies would pay on the interest earned on bank savings, dividend plans of liquid funds imposed just 14.163%. An increase in DDT reduced, though not totally eliminated, the tax benefits. As a result, ultra short-term funds emerged as an alternative vehicle.

These funds are slightly more risky than liquid funds. While liquid funds invest in bonds that mature in up to 90 days, ultra short-term funds invest in bonds that mature after 90 days. The longer the maturity of a debt, the riskier it gets. Despite that, we feel ultra short-term funds make sense.

What works

Tax benefits: Withdrawals from debt funds, including liquid and ultra short-term, attract 30.90% short-term capital gains tax. However, if you invest in a dividend plan of an ultra short-term fund, you pay only 14.163% DDT. This makes a difference in the post-tax returns. So, if you invest Rs10,000 each in a liquid fund and an ultra short-term fund, you would get Rs10,194.80 and Rs10,217.90, respectively, after six months, assuming you are in the highest tax bracket and both funds return 5% in a year.

Better alternative for short-term needs: Returns from liquid funds, an alternative avenue, have dropped significantly after the Securities and Exchange Board of India (Sebi) banned them from investing in debt papers that mature after 90 days, effective 1 May. As a result, while liquid funds have become a lot safer than before, their returns have dropped. From an average return of around 6% per year between January and August 2008, liquid funds yielded an average return of 3.61% per year between May and November this year. Mahendra Jajoo, head (fixed income), Tata Asset Management Ltd, says, “The category has stagnated and we have been advising our investors to invest in ultra short-term funds."

Ultra short-term bond funds also offer better returns than liquid funds because they invest in debt papers having higher maturity. They outperform bank fixed deposits (FDs), too, on account of lower DDT.

Easy liquidity: When parking short-term cash, it’s always better if your fund can return your cash quickly. Since ultra short-term funds invest in short-term debt papers, they offer easy liquidity. If you submit your application before 3pm, you get your money the next day, else, the day after.

Few of these funds failed miserably last year when global markets fell and investors made a rush for redemption. To pay for these, many ultra short-term funds had to sell their underlying debt papers at throwaway prices, resulting in losses that some funds passed on to their investors.

Having burnt their fingers badly, ultra short-term funds have lowered their average maturity drastically (debt papers with lower maturity are less volatile). “Besides, most funds hold around 40% of their assets in cash-type assets and government treasury bills that can be easily liquidated in the market," says Anil Bamboli, head (fixed income), HDFC Asset Management Pvt. Ltd.

What doesn’t

Watch out for a possible Sebi ruling that could make ultra short-term bond funds slightly riskier.

At present, funds are mandatedto mark-to-market an asset that matures after six months. Simply put, if the market price of an asset moves, the net asset value of the fund that has invested in this debt papers moves accordingly. Debt papers maturing before six months need not be market-linked. However, when a fund sells a non-market-linked debt papers at throwaway prices, it suffers a larger and sudden loss. This was one of the main reasons why liquid and ultra short-term funds lost money last year.

Reports say that since Sebi has already limited liquid funds to hold debt papers which mature upto 90 days, it feels there is pressing reason to mark to market instruments that mature after 90 days, down from the present 180 days. Quantum Asset Management Co. Pvt. Ltd’s debt fund manager Arvind Chari says: “This would make ultra short-term funds more volatile as all underlying scrips (debt papers) that mature after 90 days, against the ones that mature after 180 days as is the case now, would be exposed to interest rate volatility."

Money Matters take

• Keep enough cash to cover three months’ expenses in your bank account. Anything above that should either be channelized into long-term investments or ultra short-term funds if you need to park your cash temporarily.

• Avoid funds that tend to hold higher maturity debt papers. These may fetch you high returns time and again, but a redemption rush, such as in October 2008, could incur losses for you.

• Understand that ultra short-term funds come with interest rate risk. These are not completely risk-free instruments.

Graphics by Yogesh Kumar / Mint