Debt, or fixed income funds are a popular refuge for conservative investors who wish to avoid stock market volatility and yet reap twin benefits of returns higher than fixed deposits and milder tax impact. This however does not mean that debt funds are completely devoid of risk—they carry market risk—though not on the same scale as equities. The minimum holding period to avail the 20 per cent long-term capital gains tax with indexation benefit is now three years, which partially blunts the tax edge these funds enjoyed over bank FDs, before July 2014.
Liquid funds
These are meant for investors looking to park their funds with a very short-term horizon and the intent to redeem at a short notice. They are comparable to savings deposits in terms of liquidity, but offer better returns. They invest in highly liquid, short-term instruments like treasury bills, commercial papers, CDs and call money. In a declining interest rate scenario, their return-generating capability will be restricted.
Gilt funds
These are for those who wish to invest in safe government securities. However, consider your investment horizon and market conditions before taking the plunge. They do not carry any credit risk, but are vulnerable to interest rate fluctuations. Bond yields and prices are inversely related; the latter rises when the yields fall and vice-versa. A softening rate scenario will boost government bond prices—the underlying security in gilt funds— resulting in appreciation in value.
Fixed maturity plans
Close-ended schemes like FMPs have emerged as fixed-deposit alternatives that offer higher returns along with a friendlier tax structure, provided you choose tenure of at least three years. If you invest in FMPs at the end of financial year, you can maximise the indexation benefit and reduce your long-term capital gains tax. They invest in instruments which mature in line with their tenure, limiting the impact of interest rate volatility on their returns. These include government securities, money market instruments and quality corporate bonds.
Short-term debt funds
Such schemes invest in corporate bonds and government securities with shorter maturities, ranging from a few days to up to one year. Retail investors can gain by way of relatively higher returns and lower tax outgo vis-à-vis fixed deposits.
Long-term bond funds
These schemes invest in long-dated government securities and other debt instruments usually ranging from 1 year to 10 years. A falling interest rate scenario is favourable for long-term debt funds as the value of underlying bonds appreciates, puffing up their returns. Conversely, interest rate rise can pull down returns.
