A reader says, “Could you please consider writing or making a video on how investors can think about allocating across: (a) FD + Liquid Funds for near-term needs/emergency fund (1-2 Years), (b) Medium Duration Funds (2-3 years), and (c)Credit Risk Funds for medium-term goals (3–5 years), particularly for those in the 30% tax slab who are trying to generate slightly higher post-tax returns compared to FDs and liquid funds? Your framework for evaluating the risks and suitability of these categories would be extremely helpful”.
Market-linked fixed-income or debt instruments are tricky instruments. They should not be evaluated solely on returns. Understanding the underlying portfolio and how bond prices react to supply and demand is essential. Very few investors can stay invested in debt funds over the short, medium, or long term. Absolute beginners can start here: An introduction to debt mutual funds for new investors.
With debt-oriented mutual funds (holding more than 65% bonds) taxed under the slab system, the choices for the short term have become quite simple. For almost all investors, it is better to stick to bank FDs and RDs for durations of 0-5 years.
As the reader mentions, a liquid fund, a money market fund or even an abitrage fund can be used for emergencies or short-term but it is best not to expect much returns.
Some risk-aware) investors (not related to risk appetite which is often uninformed) can use debt funds for 3-5 years. Short-duration funds with excellant credit rating history* can be used by such investors.
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The medium duration funds (again with excellant credit rating history) can be for longer than 5Y duration by risk-aware investors.
* Investors must study past factsheets to get this information.
Investors who prefer a passive option for 5Y and more can consider Edelweiss CRISIL IBX 50:50 Gilt Plus SDL Short Duration Index Fund or an active option like Parag Parikh Conservative Hybrid Fund.
We strongly recommend avoiding credit risk funds for all durations. All investors want extra returns but almost all investors are not ready to accept losses, especially from debt funds.
What about tax efficiency? Tax efficient options such Income Plus Arbitrage Fund of Funds comes with extra risks which most investors do not appreciate. Therefore we recommend sticking to simple products at least for shor-term and medium-term durations (< 10 years).
For long-term (> 10 years), gilt funds or corporate bonds funds can be used but again these comes with demand vs supply risks and credit risks (in case of corp. bond funds) and not all investors may be able to appreciate them or have the patience to stay invested in gilt funds. Parag Parikh Conservative Hybrid Fund is also a good option but again for risk-aware investors.
For a tax-efficient fixed-income-like option for long-term goals, you can consider Parag Parikh Dynamic Asset Allocation Fund.
In summary, except for long-term goals, we recommend not worrying too much about the as-per slab taxation. Also see: You do not pay 30% tax if you fall in the 30% slab! Marginal vs. effective tax rate.
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