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I am 40 years old. A couple of my FDs for ₹4 lakh will mature this month. While I have the option to renew them at 5-6 per cent per annum for the next three years, I want to consider investing the same in debt and arbitrage mutual funds. I understand that there are no guaranteed returns on MFs. I can park this money for the next 5-7 years.

Please suggest what funds I can consider given the current market and interest rate scenarios. What is the advantage of considering an arbitrage fund? I also have SIPs for about ₹40,000 running across large/multi/balanced mutual funds and this money is 50 per cent of my investment.

Vishwanath S

There are three key points of difference between debt mutual funds and fixed deposits. One, while the returns on your FD are absolutely fixed, your returns from debt funds will change depending on how market interest rates behave.

Two, debt funds earn returns both by way of interest receipts on the bonds they own (accruals) and NAV appreciation or depreciation due to market interest rate changes. When interest rates in the market rise, debt fund NAVs can fall. Funds that invest in long-term bonds are more sensitive to rate fluctuations than those that invest in short-term bonds.

Three, debt funds can also suffer NAV blips when any of the bonds in their portfolio suffers a rating downgrade or default by the bond issuer.

With the RBI recently cutting its policy repo rate by another 25 basis points, interest rates in the economy appear to be close to bottoming out.

Given this market scenario, it is best for investors to invest in liquid funds or short term bond funds. It is also best not to take any risks on the credit front. We suggest that you go for liquid funds or short term bond funds.

Liquid funds typically invest in treasury bills, commercial paper and bonds with a 91 day or lower maturity.

Axis Liquid Fund, DSP BR Liquid Fund and Birla Sun Life Cash Plus are good options here. Edelweiss Short Term Income Fund, HDFC Short Term Opportunities Fund are good short term bond funds, with an average portfolio maturity of less than two years.

When investing, do not go by the past returns on these funds but maintain moderate return expectations of 6-7 per cent.

As your holding period is 5-7 years, it is best for you to choose the Growth option and allow returns to accumulate. This is also more tax efficient. As these funds are open ended, you can redeem units and withdraw money at any time. If you are in the top tax brackets, arbitrage funds can also be a parking ground for your short-term money. Arbitrage funds trade on the small price differentials between the cash price and future price of stocks to earn a ‘spread’.

As arbitrage funds are treated as equity funds for tax purposes, returns on them are exempt from capital gains tax after one year. Edelweiss Arbitrage and ICICI Pru Equity Arbitrage are good options. Their pre-tax returns will track those of liquid funds.

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