Equity markets may have rebounded smartly after the dramatic fall in May. But fixed-income instruments seem to be stealing the show these days.

After wrecking havoc in stock markets around the world, the tight liquidity scenario is finally playing to small investors' advantage. After several years, investors are finding that fixed deposit rates are climbing to respectable levels.

While 90-day bank deposits are offering around 5 per cent returns, one-year deposits are yielding 7-8 per cent. As far as mutual funds are concerned, though the future of income funds, which invest in medium-and long-term debt papers, seems to be uncertain, short-term debt funds are giving returns in excess of 6.5 per cent.

On a post-tax basis, debt schemes - fixed-maturity plans in particular - seem to be the best option for investors looking for steady returns.

Funds beat banks

Even as banks are luring investors with higher fixed-deposit rates, mutual funds seem to be steeling a march over them with FMPs. The total assets under management under these schemes have nearly doubled this year.

At the end of July, these schemes had a combined corpus of Rs 28,571 crore (Rs 285.71 billion). According to industry sources, in August alone, 14 FMPs have so far been launched with varying maturity and the total collection is expected to be at least around Rs 4,000 crore (Rs 40 billion).

The AMCs that have launched FMPs this month include Reliance [Get Quote], ABN AMRO, Principal, HSBC, UTI, HDFC [Get Quote], LIC [Get Quote], Prudential ICICI [Get Quote], JM Financial [Get Quote], DBS Chola and SBI [Get Quote].

Essentially targeted at corporate and high networth investors, FMPs combine the tax efficiency of mutual funds with the safety of fixed deposits.

The current rates on FMPs are as attractive as bank deposit rates and, thanks to the lower taxes on mutual funds, the post-tax returns on FMPs are better.

Currently, 90-day FMPs are offering around 6.85-7.10 per cent, while one-year FMPs are generating around 8.10 per cent pre-tax returns. HDFC Mutual's 26-month FMP yields 8.45 per cent for corporate investors and 8.10 per cent for retail investors.

These schemes usually come with a quarterly or annual term, and the shorter-term schemes are a huge hit with corporate investors, who usually seek to lower the tax incidence.

Mutual funds charge as low as 5-10 basis points as expenses, which is abysmally low. Even for retail investors in the top income tax bracket, these schemes make sense.

The tax edge

As dividends of mutual funds attract only a dividend distribution tax of 22.44 per cent for corporates and 14.03 per cent for individual investors vis-�-vis interest on deposits and corporate bonds, charged at the marginal income tax rate, mutual funds give better post-tax returns.

"High networth individuals have a lot of appetite for these schemes as they generate significantly higher post-tax returns," says Sameer Kamdar, national head - mutual funds, Mata Securities.

Furthermore, income from mutual fund units - held for more than a year - is deemed to be 'capital gains' and, hence, qualifies for indexation benefit. This reduces the tax incidence even more.

Thus, while a 8.1 per cent, one-year FMP would yield a post-tax return of 7.2 per cent for an individual investor in the top income tax bracket (if he opts for the growth plan), a bank fixed-deposit offering a similar rate would yield only 5.37 per cent net of tax.

Even if you opt for the dividend plan, which is less tax-efficient compared to the growth plan, for more than one-year time horizon, you would come up with a post-tax return of 6.96 per cent.

The post-tax returns indicated above are based an indexation rate of 4.5 per cent. For the uninitiated, indexation is a method wherein returns are deflated to the extent of inflation.

The tax is calculated only on the inflation index-adjusted returns. The idea is that tax on long-term capital gains must be charged only on the real returns earned by an investor. The inflation index is published by the income-tax department every year.

Similarly, 90-day FMPs, which offer 7 per cent, would yield a post-tax return of 6.01 per cent. Currently, JM Mutual and LIC are offering rates upwards of 7 per cent.

The risk factor

Though FMPs are projecting fairly high yields, these are only indicative returns. They produce predictable returns over the desired timeframe since the maturity of the portfolio matches the tenure of fund schemes.

Unlike other schemes that suffer from volatility and, hence, risk of erosion in asset value, an FMP - structured as closed-end funds - carries no interest rate risk. Whether yields rise or fall, the asset value of these schemes is protected as deposits/ bonds are held to maturity.

Still, they do not guarantee returns as bank deposits - where the interest is assured - do. Though FMPs have delivered the returns they have indicated so far, there could be a risk of asset-liability mismatch, and the investor may not finally get exactly the indicated yield.

Says Dhirendra Kumar, chief executive officer of Value Research, a Delhi-based mutual fund tracking firm, "Since there is no guarantee on the returns that funds give, there is a risk that investors may or may not eventually get the returns indicated even in case of FMPs, which are otherwise quite predictable."

Besides, if you lock in funds in an FMP you don't have the option of liquidating it prematurely. But in case of bank deposits, you can withdraw your money without any penalty. However, the interest rate you earn on the deposit would be based on the period the money is invested for.

For instance, if you break a one-year deposit after three months, you would be entitled to the interest rate applicable for the three-month deposit - and not the one-year rate.

In fact, since bank deposits can be withdrawn without any penalty, it is an ideal time for investors to close their old deposit accounts yielding lower returns and renew them at the prevailing rates.

Other debt funds

With uncertainty on interest rates receding, debt markets have rallied over the past one month. The 10-year benchmark yield has declined from 8.5 per cent in mid-July to 7.91 per cent now, and this has propped up the returns on debt fund schemes.

Most categories of debt funds have delivered returns in excess of 6 per cent. Particularly, medium-term gilt and debt funds have generated over 10 per cent returns. Should you then begin to relook at income funds?

May be, not yet.

Fund managers warn that this kind of returns may not be sustainable. On the contrary, the debt market rally looks overdone and the market may be in for some correction.

And if that happens, income funds may be back to square one. Moreover, the risk-return factor, today, is strongly in favour of short-term funds.

"The return differential between medium-term and short-term debt funds is quite narrow, and the choice must be obvious given that short-term funds offer far greater stability and slightly lower returns," says Kumar.