The RBI’s status quo on rates in the latest policy review brought welcome relief to the bond market. However, with inflation remaining a concern, the expectation is that the RBI will go for a rate hike sooner rather than later. When that happens, debt mutual funds, especially those investing in longer dated papers, are expected to see a fall in their NAVs, that is, mark-to-market loss in the near term. The spike in government bond yields (and fall in bond prices impacting NAVs) after the Union Budget, which set out a larger-than-anticipated borrowing programme for FY23, gave investors a glimpse of this.

Fixed income investors who want to play it safe in these uncertain times have a few options depending on their investment horizon.

Deposits for 1-3 year horizon

Those with a 1-to-3-year horizon can consider investing in shorter-tenure bank fixed deposits for now and reinvesting at better rates later.

While shorter duration debt funds may be an alternative to bank deposits, these are subject to interest rate risk, that is, fall in bond prices and so the fund NAV as interest rates rise, just like longer duration funds, though to a lesser extent. Also, if you redeem your investment in a debt fund any time before three years, your return (capital gains) will be taxed at your income tax slab rate as is the case with interest income from fixed deposits.

One may argue that compared to bank fixed deposits, debt funds are more liquid - you can exit your investment any time, subject to an exit load only in certain cases. But with rates expected to go up, an early exit in debt funds with a 1-to-3-year duration may expose you to interest rate risk. Returns from debt funds with a duration of less than one year, though typically less volatile, may not be very different from those of comparable bank fixed deposits. Ultra-short and low duration funds currently show a yield to maturity, a rough return indicator, of 4-4.5 per cent. Also, while a premature exit from a bank FD may entail a penal rate of interest, it is known, unlike the uncertainty of how interest rate risk will play out in a debt fund.

Many leading public and private sector banks are offering 5.0 to 5.4 per cent on their 1-2-year FDs. For example, Axis Bank offers 5.25 per cent per annum on its 1-year 11-day FD. Among the small finance banks, Equitas Small Finance Bank offers 6 per cent per annum on its 1-year FD. Senior citizens get an additional 0.5 percentage point on these rates.

TMFs for 4-5 year horizon

Like all debt funds, target maturity funds (TMFs), too, are exposed to interest rate risk, that is, a mark-down in NAVs when bond yields rise. However, investors can avoid this risk by remaining invested until maturity.

TMFs are debt funds with a defined maturity that invest passively in the bonds of a particular index. If you stay put till TMF, your indicative return will be the yield-to-maturity (YTM) minus the expense ratio. If you redeem prematurely, you face the prospect of capital loss impacting your fund returns.

Investors with moderate risk appetite, with a horizon of three years plus, can choose TMFs with exposure to State government bonds or SDLs that offer better yields than GOI bonds or G-Secs. A vast majority of these funds are maturing in the next 4-5 years. You can consider parking some money in them if the fund maturity matches your investment horizon, for a better deal than bank FDs. Most leading public and private sector banks offer 5.40 – 5.75 per cent per annum on their four-to-five-year fixed deposits.

The ABSL Nifty SDL Plus PSU Bond Sep 2026 60:40 Index Fund and Edelweiss NIFTY PSU Bond Plus SDL Index Fund – 2026 are two good options for those with a four-year horizon. The two funds mature in 2026 and track Nifty indices comprising SDLs and PSU bonds in the 60:40 and 50:50 ratio, respectively. The two can offer an annual pre-tax return (YTM minus expense ratio) of 6.27 per cent and 6.14 per cent, respectively, to those investing today and staying put till maturity. Those with a 5-year horizon can consider the ICICI Pru PSU Bond Plus SDL 40:60 Index Fund – Sep 2027 and the Edelweiss NIFTY PSU Bond Plus SDL Index Fund – 2027. Both mature in 2027, a few months apart, and track Nifty indices comprising PSU bonds and SDLs in the 40:60 and 50:50 ratio, respectively. The two can offer an annual pre-tax return of 6.52 per cent and 6.44 per cent, respectively.

Do note, the indicative returns for the ABSL and ICICI fund are based on the YTM of the index and not the fund, both of which may not necessarily be the same. Gain on sale of debt funds held for three years or longer (long-term gains) is taxed at 20 per cent with indexation benefit. This makes TMFs particularly attractive for those in the higher tax brackets.