Interest rates on short-term instruments, which witnessed a brief reversal in April 2011, have started to trend up once again.

With the RBI's expectation that inflation may continue to be stubbornly high for some more time, investors can focus on ultra short-term instruments for the next one year.

Kotak Floater Fund – Long Term (Kotak Floater LT) is a good option in this category. The fund has made full use of the sharp rise in short-term yields and returned higher than fixed deposits of banks in the last one year.

Annualised return of 7 per cent and 7.5 per cent over three and five-year periods, respectively, is superior to its benchmark CRISIL Liquid Fund index.

Strategy : Investors can consider exposure to this fund for a one-year period. Any sustained fall in interest rates would be an indicator to switch to debt funds that invest in securities with longer maturity.

This fund (floater funds in general) is preferred over fixed deposits for investors who are at the higher end of the tax bracket.

We suggest investors opt for growth option. Redemption prior to 12 months would, however, attract short-term capital gain tax which would significantly impact post-tax yields. It is the tax differentiation (if the fund is held for over a year) that makes floater funds such as this scheme superior to fixed deposits.

Performance : The fund's performance is superior to other indices such as the CRISIL Composite Bond and Short-term Bond. Both these indices returned only 4.5-5 per cent over the last one year.

Good performance of the fund was due to steep rise in money market instrument rates in which the fund predominantly invests. The three-month commercial paper and certificate of deposit rates have shot up by 4 percentage points (annualised), respectively, over the last one year.

On a one-year rolling return basis, the fund has outperformed its benchmark CRISIL Liquid index almost 95 per cent of the time over the last four years, indicative of its consistent track record.The fund's large asset size also provides flexibility to diversify its investment portfolio, thereby reducing risks.

There are not too many ultra short-term funds with a good track record available for retail investors.

Portfolio : The average maturity of the current portfolio is about three months with a yield to maturity of 9 per cent (annualised). Money market instruments (certificate of deposits and commercial papers) continue to form a significant proportion of the portfolio. While the fund can invest up to 35 per cent in fixed rate instruments of more than one year maturity, it has more or less refrained from such investments in the last one year.

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