Cash funds for short term, FMPs and FDs for long term

Cash funds for short term, FMPs and FDs for long term

These are good days for you. Your surplus cash won’t be hurting you now (as long as it is not lying in your savings account). For the past three years, you have been struggling with very low returns on your investments in both fixed deposits and debt mutual funds. It’s unfortunate that all that you wanted to buy was getting costlier over the last three years (they call it inflation), but your savings were giving lower and lower returns. Why was that? During the last two years, the world’s economy witnessed a great recession (why “great"? Because it was the longest-ever recession since World War II), causing a drop in interest rates across the globe. As for India, growth slowed down, but didn’t collapse. This slowdown was unique since prices of essential commodities didn’t fall as much as interest rates did. Prices of global commodities came down but consumables didn’t show any explicit price drop. Rent, food and fuel—representing most of your wallet’s load—didn’t show any meaningful sign of price correction.

The situation began to change by mid-2010 as the world economy stabilized and our policymakers shifted focus on controlling price rise. The cost of money was increased and its availability constrained. The dual tightening blow by the central bank (by way of tighter liquidity and higher policy rates) have over the past quarter hardened short-term rates by 2-4%. In other words, money is costliest since November 2008. To put things in perspective, your banks never ever borrowed at rates prevailing today in the month of December over the past seven to eight years.

Will inflation come off? Investors should recognize that average inflation in the past seven years has been 5-6% and while inflationary expectations have remained elevated through FY10 and FY11, the Reserve Bank of India’s policy hawkishness, which has rendered funding costs well above their past five-year averages, is potent enough to tame price growth.

What should you do

Keep your temporary surpluses or savings in cash funds. They give far better returns than bank savings account. It’s likely that cash funds would generate 7-8% over many months. These funds run little risk given that most of them invest in bank company deposits (FDs) and highly rated corporate commercial papers.

Invest in fixed maturity plans (FMPs) and short-term funds to park your savings for more than three months. FMPs are funds where both yours and the fund’s investment horizon is fixed. Assume you invest in a one-year FMP, your fund manager will invest in a one-year instrument, too, and your money will remain locked for a year. Returns in FMPs should reflect the prevailing rates in the markets. Since short-term rates have moved up substantially, it’s a good time to invest in FMPs. Short-term funds are typically open-ended funds where you should invest as long as your investment horizon is six months and above. These funds try to optimize returns for the said term by benefiting from curve dislocations. These funds run lower risk than gilt and income funds. Historically, short-term funds have returned better vis-a-vis cash funds across time frames.

Remember to invest your temporary cash in cash funds and lock your permanent money for the long term in FMPs and FDs during January-March. Always be careful of credit risk. Remember that unlike equity, debt has only the coupon rate as the upside and the full principal as downside. Fixed income is all about earning regular income with a lot of certainty. Don’t trade your peace of mind for unnecessary and unknown risk. Avoid long-term income funds for the first half of the year as spreads are likely to widen. Look for investing in short-term funds in the January-March period. Try some gilt funds in the second quarter when most of the pain of large government borrowing will be in the rates.

Maneesh Dangi is head (fixed income), Birla Sun Life Asset Management Co. Ltd.

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