Short-term Debt Funds provide a temporary shelter for your funds, During times of inflation and high interest rates

The equity and debt markets are both under fire. Two major equity indices, the BSE Sensex and S&P Nifty, are both down by almost 31 per cent from their all-time highs of 20,873.33 and 6,287.85, respectively, in January 2008. The debt route is reeling under the effects of double-digit inflation. So, what to do if you want to stay away from equity temporarily or want debt in your portfolio?

With high inflation, many debt options like fixed deposits are giving negative returns. On an average, bank fixed deposits give 8-8.5 per cent returns, while inflation is above 11 per cent (see Effect of Taxation). Long-term debt funds have also been severely affected as prices of outstanding bonds, bought at lower rates, fall to bring their yield in line with the higher-interest new bonds. So, in the present market, short-term papers will give higher yield than long-term papers. In such a scenario, what’s needed are funds that benefit from increasing interest rates.

Short-term market-linked instruments like Liquid or Liquid Plus Funds, Floating Rate Funds (FRFs), Fixed Maturity Plans (FMPs) and Monthly Income Plans (MIPs) could be your escape route for now.

While the first three benefit from portfolios constructed to deliver market-linked returns, MIPs benefit from a small equity exposure. Further, due to rising short-term interest rates, these funds can benefit from investments in commercial paper.

These funds are most suitable for those looking to park their funds as long as interest rates remain high. Although it is not possible to predict the exact returns, investors can expect returns to be close to the inflation figure. This will result in positive, post-tax, post-inflation returns.

Liquid Plus Funds (LPF). These schemes basically invest in short-term debt instruments like treasury bills, inter-bank call money market, short-duration corporate papers and corporate deposits. In unstable markets, a typical LPF can score by taking exposure to short-term bonds, that is, papers having high yield, along with sufficient exposure to money-market instruments that can gain from increases in overnight rates of inter-bank call money. LPFs can also change their portfolio yield based on high-duration bonds (bonds with maturity more than a year). Thus, LPFs provide easy liquidity and help to protect capital erosion.

Who should invest. Anyone looking to park money for anything between one week and two months can use this route.

Floating Rate Funds (FRF). FRFs actively reset their yields at different levels according to their benchmarks, thus giving them benchmark-like returns. So, in the current situation where high inflation is pushing up interest rates, which is reducing liquidity and thus increasing yield, this is good news. This is why FRFs have done better than other short-term debt funds (see: Short-term Fund Returns).

FRFs protect your investments from interest rate fluctuations by closely tracking interest rates, and, thus, giving higher yields. FRFs, especially short-term FRFs, make more sense than other long-term debt products.

Tax Matters for Debt Funds:

Before investing in any debt fund the tax implications should be understood fully. Dividend distribution tax (DDT) of 14.1625 per cent (12.5 per cent tax, 10 per cent surcharge and 3 per cent education cess) is levied on debt funds. If you sell the units before a year is over and there is a gain, short-term capital gains tax is applicable. The net gain will be added to the current income and tax will be levied on this amount. If you sell units after a year, 10 per cent long term capital gains tax will be levied, or 20 per cent with indexation.