No matter how open to risk one is, in the form of taking exposure to equities, the less volatile asset class—debt—always remains an essential component of an investment portfolio. Debt funds, which we covered in Knowing Debt Funds, 3 November 2010, invest strictly in debt-related securities. They can be either long-term or short-term, so it is important to assess your financial requirements before you buy one.

Long-term funds usually invest in securities with a maturity of over a year, giving steady income. They are slightly more volatile than short-term debt funds.

Short-term funds. Short-term debt funds are open-ended income funds with a short-to-medium-term focus. With an average maturity of 1-2 years, they invest mainly in money market instruments, certificates of deposit and commercial papers. In addition, they take some exposure to long-term government securities or corporate bonds—10-35 per cent of their corpus—to earn higher returns without taking too much risk. A short-term debt fund does not invest significantly in securities having longer maturities even if interest rates are falling rapidly. When interest rates are expected to rise, short-term bond funds are a viable option. There is an inverse relationship between bond prices and interest rates.

The average credit quality of a fund is generally maintained at AAA or its equivalent. This allows it to hold securities of varying maturities to maintain a certain level of liquidity to fund redemption requests. In some schemes, the fund house may reduce the quality of papers in its portfolio in the chase for returns. As an investor, you need to be prepared to take on a higher element of risk if you invest in such schemes.

Long-term funds. In addition to holding securities with long maturities, long-term debt funds may hold government securities (G-Secs). Gilt funds, which mainly invest in G-Secs, are the most volatile due to their long maturities (20 years or more). They can generate high returns when interest rates are falling, but are hit hard when interest rates rise.

The difference. Both short- and long-term debt funds suit investors who rate consistency over the volatility associated with returns from equity funds. They are a good choice for people looking to park their surplus funds for the short term and earn better returns than those from liquid funds. Long-term plans may offer higher returns when interest rates are falling. When they are rising, short-term funds may be a better option. In debt instruments, the interest paid every year or at pre-decided intervals (called coupon) and interest rate risk increase with tenure.

Bond prices rise (or fall) in reaction to a decrease (or increase) in interest rates. The quantum of such changes increases with increase in tenure. In debt funds, what matters is the 'average portfolio maturity' and 'modified duration'. As most long-term gilt funds have an average portfolio maturity of over 10 years, the highest among all kinds of debt funds, they are among the riskiest debt investments in terms of fluctuation of returns. But, as G-Secs are issued by the government, they have no default risk.

Return options. Returns from funds come from either the dividend payout on the scheme (under the dividend option), or a change in its NAV under the growth option. In the latter, any profit made on the investment is not distributed, but retained in the scheme. In the former, the investor gets back the return as dividends, resulting in a fall in the NAV. In addition, there is a dividend reinvestment option that combines features of both the options. Here, the dividends are declared but reinvested in the same scheme at the ex-dividend NAV.

Dividends from equity funds are tax-free, but those from debt funds are subject to dividend distribution tax (DDT) in the hands of the resident investor at 13.84 per cent (27.68 per cent for liquid funds), including surcharge and cess. As this tax is paid out of the dividend earned, the return is usually much less than the growth option. Investments made for less than a year under a debt fund's growth option attract short-term capital gains tax. For debt instruments, the tax is calculated as per your slab.