Since some time now, mutual funds have become synonymous with equity schemes. Hardly anyone has looked at debt in the recent past. Even if debt exposure is sought, it is through balanced schemes. Or liquid funds or floating rate funds are used as a temporary parking place for cash. However, things are changing.

Everyone knows that interest rates have been rising. On the borrowing side, home loan buyers are already paying almost two per cent more. On the investing side too, eight per cent is being offered on a one-year deposit. Could anyone have had imagined this six months back? Which is why they say, when it comes to forecasting interest rates, either predict a date or a rate but never both.

Will this rise in interest rates be secular? In other words, will rates continue to rise or at least be maintained at this level? Or will they fall back again? I repeat once again --- Either predict a date or a rate, never both.

Just like stock prices, interest rates too will rise and fall; however, no one can say which will happen when. Increasingly we live in a volatile climate --- both locally as well as globally. Geopolitical tensions, commodity prices particularly that of oil, the consequent impact on inflation, trade flows, government policies, the threat of terrorism --- all these factors and more ultimately combine to impact rates and therefore an accurate prediction is almost an impossibility.

However, what we do know is that at least in the near future (short-term), interest rates have climbed. An 8.5 per cent to 9 per cent return on short-term debt is definitely possible. The uncertainty prevailing amongst market players can be clearly gauged from the fact that currently the return on even long-term fixed income paper is not much different. (The 10-year government bond yield is going at 8.20 per cent). Normally, there should be a premium for committing your funds for a longer period of time.

Be that as it may, it is indeed possible for investors to avail of the aforementioned rates for little or no risk at all. However, the choice of fund is important. Remember that this is not true for all income schemes available in the market. The average one-year return on most income schemes is still a paltry 4-5 per cent p.a. This happens on account of the fact that existing income schemes are saddled with already invested paper languishing at lower rates. When the current rates in the economy start to climb, this existing low yield paper has to be sold at a discount thereby lowering the 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, the prices of fixed income earning instruments fall and vice versa. This is called the interest rate risk and adjusting the portfolio to the market rate of return is 'Marking to Market'.

To illustrate, we assume that the current NAV of the MF is Rs 10 and its corpus is Rs 1,000 crore (Rs 10 billion). Now suppose, the interest rate rises from 6.0 to 8.0 per cent. Immediately thereafter you wish to invest Rs 100,000 in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 6.0 per cent.

If the fund sells the units to you at it's 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 8 per cent will be shared by all other investors too.

This is injustice to you. Therefore, something has 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 7.50. You will be allotted 13,333 units and not 10,000. The return on 13,333 units at an NAV of Rs. 7.50 would be the same as that of 10,000 units at Rs. 10.

In other words, the NAV falls when the interest rates rise and vice versa. To put it differently, when interest rates rise, the value of long-term debt gets diluted.

Getting out of the trap

There are two ways that one can get out of this trap. One is by holding the investments till maturity.

Realise that interest rate risk discussed earlier only comes into play when a transaction is undertaken during the pendancy of the fixed income instrument. Ergo, it follows that if the investment is held till maturity, there would be no interest rate risk. Which is why, in investments such as PPF, Relief Bonds etc. there is no interest rate risk, as these investments are normally held till maturity.

Fixed Maturity Plans is another example where the mutual fund scheme concerned invests in underlying securities where the balance maturity period is the same as the tenure of the FMP, thereby eliminating the interest rate risk. However, funds invested in FMPs are locked in for a duration of the scheme and withdrawal if at all permitted is at a steep load.

The other way out is by investing in short-term instruments where there is minimum fluctuation in interest rates and hence there is little or no interest rate risk. Here is where short-term income schemes of MFs where the average maturity of the portfolio is extremely low comes in. These offer an opportunity for diversification in relatively stable fixed income instruments where the portfolio does not contain extra baggage accumulated over the years.

For example; the portfolio of Reliance [Get Quote] Short-term plan has an average maturity of just 338 days. With a low expense ratio and no load on entry as well as exit, such plans offer an excellent avenue for earning healthy returns at very low risk.

While it is true that a safe bank deposit earns 8 per cent per year, remember that this is fully taxable. At a 30 per cent tax rate, the return plummets to 5.6 per cent. At 33 per cent tax, the return is a paltry 5.36 per cent, which might not be enough even to cover true inflation. On the other hand, for short-term income schemes, being a non-equity fund, tax @10 per cent would be applicable across all tax slabs.

If you are looking to diversify your portfolio by adding fixed income, Short Term Income Plans could be a wise choice.

The author is the Director of A N Shanbhag NR Group, a Mumbai based tax and investment advisory firm. He may be reached at sandeep.shanbhag@moneycontrol.com

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