Tuesday, December 27, 2011

Liquid Plus Funds of mutual funds

A few days ago, the Reserve Bank of India (RBI) announced the credit policy. Most of what is said seems like Greek and Latin, and we quickly scan the newsprint to see whether deposit rates are going up, or interest on loans could come down; and when we see the opposite, we are, of course, disappointed. But the RBI uses the credit policy to signal what it wants banks to do. In the recent policy, repo rate — the rate at which RBI lends overnight to banks — was raised 0.25% or by 25 basis points to 5.75% pa, and the reverse repo rate — the rate at which RBI absorbs the surplus overnight funds from banks — was hiked by 50 basis points to 4.50% p.a.

Overnight Funds with Banks

So, as you freely deposit and withdraw money on a daily basis, your bank needs to ensure that it earns money on your deposits, especially as they now pay you interest too on a daily basis. If no other bank wants to borrow money in the inter-bank call money market, your bank will invest these funds with the RBI and earn 4.5% p.a. Obviously they will lend to another bank at a higher rate than that as, for the other bank, that would be cheaper than borrowing from the RBI at 5.75% pa (repo rate). The reason why the bank needs to borrow funds overnight is that they need to maintain a statutory liquidity ratio of 25% and a cash reserve ratio of 6% of the bank’s net demand and time liabilities.

How does this impact you?

The money that you have in your savings bank account earns you 3.5% pa at present. Since the interest rate corridor, or the difference between repo and reverse repo rate, has been reduced, inter-bank and short-term interest will move in a narrow band between 4.5% and 5.75% pa, and these are returns that liquid plus funds could earn. By now, of course, you are well aware that mutual funds have a tax advantage over bank deposits for those in the higher tax bracket — 20% or upwards. So, do consider moving your idle funds in the bank to liquid plus funds, which normally carry no entry or exit load.

Longer term investments

Mutual funds also offer investment opportunities in fixed income products for the longer term such as government securities and corporate bonds. While these instruments carry a fixed rate of interest or coupon, the market rate of these fluctuates virtually on a daily basis. As a result, values of these schemes can fall in the short term: this happens funnily when interest rates are rising. However, if I do buy a bond which will mature in, say, 3 years, and hold on till maturity, I can be oblivious of these daily price movements.

Past track record

I did a study on the performance of a decent performing government securities fund, and found that, while it had fallen 0.08% in the past one month, appreciation in the past one year was over 11%, and the 3-year returns were a healthy 10.6% p.a. compounded annually. After long-term capital gains, this meant a very attractive post-tax return of 9.5% p.a. Similarly, a short-term debt fund has earned 7.3% in the past one year, or an equivalent of earning 10% on a 1-year bank deposit for someone in the highest tax bracket. Do consider debt mutual funds to increase the possibility of returns, but under supervision of a competent financial advisor.

Source: Economic Times

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