A direct fallout of the global economic downturn coupled with stubborn domestic inflation has been prolonged stock market volatility. Though the Sensex has finally crossed the 20000 points barrier, the frequent rises and downturns are quite sharp and difficult to digest for the risk-averse investor. Consequently, investors have turned to investing in fixed income avenues in an attempt to preserve capital and at the same time earn a return that will at least cover inflation. Obviously bank fixed deposits are very popular; however, another avenue that has the potential of delivering possibly higher returns are ultra short-term/liquid mutual fund schemes. Moreover, this product is more liquid and tax efficient than its fixed deposit counterpart.
While it is indeed possible for investors to avail of high interest rates for little or no risk at all, however, this cannot be achieved by investing in any random income fund that is available in the market. Identification of the appropriate type of fund is important. For regular income schemes, the average one year return is around just 5.5% to 7% p.a. This happens on account of the fact that existing schemes are saddled with paper already invested in the past at lower rates. When the 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, bond prices fall and vice versa. This is called the interest rate risk and adjusting the portfolio to the market rate of returns 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 crores. Now let’s say, the interest rate rises from 8% to 10%. Immediately thereafter you wish to invest Rs. 1 lakh in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 8%. 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 10% will be shared by all other investors too. 
This is unfair to you. Therefore, something has got 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. 8. You will be allotted 12,500 units and not 10,000. The return on 12,500 units at an NAV of Rs. 8 would be the same as that of 10,000 units at Rs. 10. 
In other words, interest rates and prices of fixed income instruments move in opposite directions – the NAV falls when the interest rates rise and vice versa. Or 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.
Interest rate risk only comes into play when a transaction is undertaken during the currency 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, for investments such as Bank FDs, Relief Bonds etc. there is no interest rate risk as these investments are normally held till maturity? Fixed Maturity Plans (FMPs) are 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.
The other way out of course is investing in income schemes that do not invest in long-term debt. Here is where the above mentioned ultra short-term plans of mutual funds come in where there is minimum fluctuation in interest rates and hence little or no interest rate risk.   These funds invest in debt paper having a short maturity of generally between six to eighteen months. This covers instruments such Commercial Paper (CPs), Certificates of Deposit (CDs), other money market instruments and bonds with short outstanding maturity. 
Where these funds score over the bank FD are on the risk-return, liquidity and tax efficiency parameters. While a safe bank deposit nowadays earns around 9% p.a, remember that this is fully taxable. At a 30% tax rate, the return plummets to 6.3%. On the other hand, for an ultra short-term fund, being a non-equity scheme, tax @10% would be applicable across all tax slabs. This tax arbitrage jacks up the effective rate of the instrument and hence, the mutual fund plan scores above a bank fixed deposit. 
The only major concern that an investor could have is that the return of ultra short-term funds over the past one year as a category average has been around 8.5% p.a. which is lower than the return from a bank FD. However, comparing the historical return of one instrument against the future return of another is not correct and leads to sub-optimal decision making. 
In other words, though a bank FD and an ultra short-term fund are similar in substance, they differ in form. A bank FD specifies the rate that’s on offer for the future. However, mutual funds aren’t allowed to guarantee or specify returns. Instead the investor would get the return that the underlying portfolio earns post expenses. In these circumstances, typically investors try to gauge how good a fund is based on the past performance. While, past performance may be an effective tool to compare equity oriented funds, for a debt fund, in an uncertain yet dynamic interest rate scenario as exists currently, it would throw up an erroneous conclusion.
To Sum: Therefore, if you are looking to diversify your portfolio by adding a dollop of debt investments, ultra short-term income funds or liquid funds could be a wise choice at this time.