Despite their lock-in periods, these options are attractive because of their high returns (even after tax), which remain out of sync with the rest of the market. And that they come without any default risk is the icing on the cake. You can also claim tax exemption on interest receipts from all these options under Section 80L.

Investors who are not confident of calling the direction of interest rates, may permanently park a part, say, 20 per cent, of their portfolio in floaters, as a measure to protect against rising rates. But do not switch your entire debt portfolio or even a lion's share of it into floaters, as this would be a gamble on continually rising rates.

In theory, as long as your holding period in fairly long-say 4-5 years, interest rate changes should not make a difference to your holdings even in a long term bond fund, as interest receipts may make up for the fall in bond prices. But it may still be better to stick to short-term plans for now. For one, it is often difficult to predict your holding period in advance. Second, there could be an opportunity loss involved in staying with long term bond funds. By staying invested in a long-term fund, you would be losing out on the opportunity to benefit from a spike in interest rates in the near term, which you could do with a short term plan or a liquid fund. Significant pullouts by savvy investors could also prevent long-term bond funds from taking advantage of opportunities presented by rising interest rates.

Considering these risks, it may be best to retain a modest portion of your portfolio in diversified bond and gilt funds which pack their portfolios with long-term bonds.

But remember, even here, you are assuming the risk of wrong calls on the markets or in fund selection by the investment manager.

The temptation to invest even a small portion of your debt portfolio in equities for the much-touted "kicker" to returns may be high. If you are unwilling to risk losing any of your capital, resist the temptation. Remember, the equity markets can wipe out in a single month what your debt portfolio may earn over years. Be patient instead.

If interest rates continue their upward journey, investments in fixed deposits and short-term income funds may once again begin to deliver inflation-beating returns, as rising interest rates work their magic on your investment.

Bond with the fundas

FUND houses today offer a dizzying array of products for debt investors. A few of them are relevant only to big institutional investors.

For retail investors navigating debt funds, here is a primer on what the names mean and when one should invest in each debt fund:

Diversified bond funds (commonly known as bond funds or income funds): Designed to invest in a diversified basket of bonds bearing fixed interest rates.

These funds usually invest a large portion of their portfolio in corporate or government bonds which are set to mature in a specified number of years from now, usually more than three-four years. Will perform best in a falling interest rate regime, as they derive their returns from interest receipts as well as changes in bond prices.

Gilt funds: Invests only in government borrowings, usually of longer maturities, as above. Also performs best when interest rates are tumbling.

Medium- and short-term plans: Variations of diversified bond funds, which restrict themselves to borrowings with a shorter lifespan. The portfolios of short-term plans usually mature on an average of 1-2 years, while medium-term plans may carry slightly higher maturities.

Short-term plans depend more on interest rate receipts than on changes in bond prices for returns. May outpace long-term bond funds in a rising rate regime, as short-term bond prices are less vulnerable to rate changes than are long-term bonds.

Most fund houses set fairly high minimum investment limits for these plans, designed for institutional investors.

Liquid/cash/money market funds: Invest only in highly liquid and very short-term corporate borrowings, treasury bills and money market instruments. Depends mainly on interest income for returns. Low risk of capital loss. Good avenue for parking short-term surpluses, no matter where the rates are headed.

Floating rate funds/floaters: Invest mainly in bonds which carry interest rates which are likely to be reset upwards or downwards in line with market rates. Will earn higher returns when rates are rising and lower returns when rates are falling. Good for protecting against risks of changes in interest rates.

A word of caution

When investing in a debt fund, don't go by the name alone. Two different products with similar names, such as `Income Plus' or `Bond Fund', may often sport widely different portfolios.

Check out the investment objectives from your distributor before committing your funds.

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