First, debt funds invest in a basket of securities with varying credit quality and tenure. Coupon is directly linked to the tenure of a bond (longer the term of securities, higher will be the interest).

Second, unlike FDs, debt funds are also hit by price movements in underlying instruments. The cardinal rule is that prices and interest rates move in opposite direction. Thus, an active management of portfolio, where debt funds supplement interest income with price gains makes them an ideal investment vehicle.

Dividend Tax
The budget has reduced dividend tax to 10.2 per cent (including surcharge) from the existing 22.4 per cent. In fact, the effective dividend tax is still lower at 9.25 per cent if you take the tax liability as a percentage of the total outflow (dividend and dividend tax). With a lower dividend tax, funds will now be able to reward their investors with higher dividends in debt funds and monthly income plans. The coupon on closed-end MIPs of UTI, which is yet to be announced for the next fiscal, would also factor in the cut in dividend tax. Thus, investors can expect a higher dividend payout next year. Cut in dividend tax would also mean a sharply lower tax liability for average investor, who was burdened with a 22 per cent dividend tax last year even though he had the necessary limit under section 80L. Deduction u/s 80L of Income Tax Act The deduction available on interest income from securities like bank deposits, specified bonds u/s 80L would now stand reduced from Rs 12,000 to Rs 9,000. This means thatinterest income above Rs 9,000 will come under the ambit of normal tax rates (depending on your tax bracket). As a result, inflows in bond funds will be higher, as the tax rates are far lower (only the dividend tax).

Some medium-term debt funds
Templeton India Income Fund (TIIF) has performed steadily with its quality portfolio and aggressive management. The fund aims at minimising credit and liquidity risks and actively manage interest rate risk.

Currently, it has 94 per cent of its assets in Triple A rated instruments. Since launch in March 1997, it has given an annualised return of 13.64 per cent.

Sundaram Bond Saver, a medium sized fund, follows a nimble footed strategy but is conservative while handling interest rate risk. Through its tenure, the fund has maintained around 70 per cent exposure to Triple A rated papers including government bonds. It has also retained an average 20 per cent exposure to double A and un-rated papers in year 2000, which chip in with higher interest income. The fund has so far yielded a return of 13.16 per cent since launch in November 1997.

Prudential ICICI Income Fund is the largest sized open-end debt fund with AAA portfolio (at an average 85per cent). While staying cautious on maturity front, PIIF has effectively handled its gilts exposure to align portfolio in line with interest rate expectations. While the fund may not offer blockbuster returns, it offers top rated bonds with emphasis on steady returns. The fund has posted a reasonable return of 12.67per cent since launch.

Value Research