Personal Finance

Three types of funds to park your windfall

Aarati Krishnan | Updated on March 31, 2019 Published on March 31, 2019

While bank deposits score high on safety, some MFs offer better returns and tax efficiency

All of us dream of sudden riches, but when we’re confronted with it, we’re not sure what to do about it. You may have made a packet from selling a land or had a rich aunt leaving you money. In such situations, you would like a short-term parking ground for that money, until you can decide what to do with it. While parking windfalls, your priorities should be safety of capital, any-time liquidity and tax-efficient returns, in that order.

Short-term bank deposits are often the most popular choice for investors looking to park their windfalls. Banks are currently offering rates of anywhere between 4 and 6.25 per cent per annum on their fixed deposits of up to six months. But premature withdrawal will require you to sacrifice up to 1 per cent of those returns. Select banks offer interest rates of 6 per cent on savings accounts, too. But there are three types of mutual fund products that can be considered for parking your windfalls. Here are their pros and cons.

Liquid funds

Liquid funds, which offer market-linked returns, are open-ended debt schemes that invest in a mix of short-term government borrowings (treasury bills), commercial papers and money market instruments.

Liquid-fund returns have typically averaged 7-7.5 per cent in the last five years, but could be lower this year. A tightening of SEBI rules on valuation of debt securities has prompted liquid funds to reduce the maturity of the securities they hold from 90 to 60 days, with a shift to 30 days likely now. This is likely to trim liquid fund returns by 0.30-0.50 percentage points. However, with returns of 6.2-6.5 per cent, they would still compare favourably to bank fixed deposits, with the added facility of any-time exit. Those returns can edge higher or lower with fluctuations in market interest rates.

Liquid funds that take high exposure to corporate paper may manage higher returns of 6.5 per cent plus. But that entails risks. In the past couple of years, some liquid funds have owned exposures to IL&FS, Amtek Auto, etc, that suffered sudden defaults or rating downgrades, and have suffered value erosion as a result. But not all liquid funds take on credit risks, and if safety is your priority, you must pick liquid funds that invest mainly in treasury bills and CBLO (collateralised borrowing and lending obligation) and hold low or nil exposure to commercial papers. Quantum Liquid Fund, Parag Parikh Liquid Fund and Motilal Oswal Liquid Fund are a few that fit this description.

In terms of tax-efficiency, liquid funds are not much better than bank deposits if you park money for less than three years. Growth-option returns are taxed at your slab rates as short-term capital gains.

Overnight funds

A new category of debt funds permitted by SEBI — overnight funds — present a safer option than liquid funds, while offering you any-time exit. Returns from overnight funds are subject to the same tax treatment as liquid funds.

Overnight funds invest much of their money in reverse repos, CBLOs or corporate bond repos. The CBLO market operated by the Clearing Corporation of India allows banks, insurers, companies and other financial entities to borrow quick money, while offering government securities as collateral.

The one-day maturity of overnight funds protects their NAV from shocks due to interest-rate spikes.

As they lend money against high-quality collateral, credit risks are minimal, too.

In the last month, overnight funds have returned 0.46 per cent. This translates into annualised returns of 5.5 per cent compared with the 6.2 per cent returns from the liquid category. That’s the price you pay for their higher safety.

Arbitrage funds

If paying a 30 per cent tax on returns irks you, mutual funds also offer arbitrage funds that are tax-efficient. Arbitrage funds trade on the cash-futures arbitrage in individual stocks, to notch up steady returns on a month-to-month basis.

While arbitrage funds invest in equities, their returns are debt-like because they don’t bet on stock price movements.

Returns from arbitrage funds have averaged 5.5 per cent in the last year.

Those returns fluctuate based on short-term borrowing rates in the market and market conditions. Arbitrage spreads tend to be higher in bullish and volatile markets.

While the absolute returns on arbitrage funds are low in relation to liquid funds and bank deposits, their USP lies in their tax treatment as equity funds. Returns on arbitrage funds for periods less than a year are treated as short-term capital gains and taxed at a flat 15 per cent.

Effectively, with arbitrage funds, you can get away with paying just half the tax that you would pay on savings accounts, bank deposits or debt mutual funds.

Published on March 31, 2019

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