 Dodge the interest rate trap vis-a-vis debt fundsPublished on Thu, Aug 24, 2006 at 11:53 | Source : Moneycontrol.com Updated at Mon, Aug 28, 2006 at 17:10 Like this story, share it with millions of investors on M3
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.
Fixed Maturity Plans (FMPs) 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. (Check out - Fear interest rate risk? FMP is the solution) 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 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% p.a, remember that this is fully taxable. At a 30% tax rate, the return plummets to 5.6%. At 33% tax, the return is a paltry 5.36%, 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% 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. - Sandeep Shanbhag 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 For more Columns by Experts click here
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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. 
