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Simple and Smart Strategy to Buy the Best Debt Funds

No, Debt Mutual Funds are NOT untouchables.

Despite the recent losses (which could after all turn out to be only notional), it makes lots of sense to buy debt funds. The key point, however, is to "buy the best". But, before, I discuss how to buy the "best" debt funds, let me first answer the more fundamental question - Why should I invest in a debt mutual fund?

The answer to "Why" is pretty simple and straightforward - Tax!!

Normally, both Bank Deposits and Debt MFs will yield more or less similar pre-tax returns. 

However (assuming more than 1 year as the investment horizon), you would have to pay 10% long term capital gains tax in case of debt MFs. Whereas bank deposits would be taxed as per your slab rate. Hence, on a post-tax basis you will make more money in debt MFs, if you fall under the 20 or 30% tax bracket. 

Now we come to the subject matter of this article.

Recent events have made people aware of the fact that debt MFs are prone to what is termed as the "interest-rate risk". (See 'OMG! I lost money in debt funds'). So the "best" debt funds are those that are able to manage this interest-rate risk efficiently and deliver good returns.

From this interest-rate risk perspective, three scenarios are possible.

Scenario 1: Rising interest rates
If the economic conditions foretell a trend of rise in interest rates, it is best to stick to liquid funds, ultra short-term debt funds, short-term debt funds, floating rate funds and fixed maturity plans.

Scenario 2: Declining interest rates
If the economic conditions foretell a trend of fall in interest rates, long term funds would make good money for you...sometimes really good money!

Scenario 3: You can't make out any trend
If you do not have time to actively monitor the economy or do not notice any firm trend, go for the dynamic bond funds. Let the fund manager take the call. In fact, for most investors this would be the best way out, instead of themselves trying to time the interest-rate cycles.

That's it! It is as simple as this.

(And a couple of more points to check, once you zero-in on the best type of fund: Very good credit quality of the portfolio and Minimum Exit Loads).

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