For most Indians, traditional savings seem a natural choice, but with falling interest rates investors can explore debt mutual funds as they have the potential to earn relatively higher returns albeit with higher risk. However, the underlying volatility can be managed effectively by diversifying investments in different types of debt funds.

A major benefit of debt funds is the variety and convenience they offer. One can invest in debt funds for even one working day (overnight funds) to a few weeks (liquid funds) or a few months (ultra short duration funds). There are debt funds for the short to medium term (short term duration funds) and long term (income and gilt funds). Hence one can spread and map their debt investments in different types of funds based on a goal’s horizon, liquidity needs and risk appetite.

One may also utilise the ‘systematic’ avenues of investing in mutual funds like SIP (Systematic Investment Plan), STP (Systematic Transfer Plan) or SWP (Systematic Withdrawal Plan) all of which may not be available with traditional avenues. Another benefit of debt mutual funds is that they have the potential to offer better yields vis-a-vis traditional savings mainly due to the former’s portfolio based approach of optimizing yields across corporate and/or government bonds.

Further, one aspect of debt funds which many are not aware is that debt funds can work to your advantage both in a rising and falling interest rate scenario. As we are aware, bond returns are a function of yields (accrual returns) and capital appreciation. Further bond yields and prices move in the opposite direction. Hence in case yields rise, bond prices would fall. Also, prices would fall more in case of long term bonds than short term bonds.

Hence short term bond funds tend to benefit when yields (interest rates) rise as their bonds not only capture accruals but their prices also fall less than long term debt funds. However when yields fall and prices rise, generally long term debt funds benefit more than short term debt funds from the rise in bond prices.

While many may increase their exposure to traditional debt products when interest rates rise, they are not aware of favorable investment avenues when interest rates fall. Thus debt mutual funds provide a convenient mode of investing across time horizons as well as across interest rate scenarios.

Going further, another advantage of debt mutual funds is the indexation benefits they offer for investments held for more than three years. Indexation refers to the advantage of allowing only the inflation adjusted returns to be taxed vis-à-vis the total interest earned that is taxed in case of traditional debt products. It means if you hold debt mutual funds for a period beyond three years, the tax you need to pay on capital gains would be allowed to be adjusted for inflation (indexation benefits). So if returns are 7% p.a. and inflation is 6% p.a., you pay tax only on the differential returns of 1% p.a. for this period.

This may lead to a question that if there is no tax advantage (for an investment horizon of less than 3 years), should one hold debt funds or traditional savings. The answer would be to invest as per one’s risk appetite. If one has some appetite for risk, debt mutual funds may be preferred for their potential to generate higher returns. Being actively managed, they endeavor to provide higher returns owing to two aspects – potentially better yields of the underlying debt instrument and price appreciation of these instruments, if any. However, one must note that mutual funds cannot assure returns like traditional debt products and all returns are market-linked.

Summing Up

Debt funds offer variety, convenience and tax efficiency due to indexation benefits over three- year period. Despite being a market-linked product, an investor can manage volatility in debt funds by diversifying investments across different types of debt funds based on one’s goals, time horizon, and risk appetite.

Information contained in this article is not a complete representation of every material fact and is for informational purposes only. The recipient is advised to consult his/her advisor/ tax consultant prior to arriving at any investment decision.