I want to invest about 3 to 4 lacs in Debt funds or Fixed Deposits

You should be clear about your investment objectives and timeframe. FDs will give you assured returns, while Debt funds cannot give you assured returns. However, debt funds offer a wider array of investment choices compared to FDs and also over a investment horizon of 3 years or more, debt funds are much more tax efficient than FDs, especially for investors in the higher tax brackets. For Debt fund investments held over a period of 3 years or more, the returns are taxed at 20% after allowing for indexation benefits, whereas FD interest is taxed as per the marginal tax rate of the investor.

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As you would have observed, most banks have reduced their fixed deposit rates. When further rate cuts are announced by the Reserve Bank of India (RBI), the fixed deposit rates will decline further. Debt funds offer a range of products over the whole spectrum of investment timeframes and interest rate scenarios. For short term investments, say for 1 to 2 years, you can invest in short term debt funds and credit opportunities fund or corporate bond funds. Both are accrual based debt funds, in other words, they have limited interest rate risk. Credit opportunities funds will enable you to lock a few percentage points of higher yield. However, you should make sure that you invest in a good fund from a good fund house. For long term investments, you can invest in long term income funds and gilt funds. Gilt funds can give higher returns than income funds, but they are also more exposed to interest rate risk and the returns of gilt funds can decline if yields harden. However, the RBI governor in the last policy meeting has reiterated his accommodative stance, which can safely be interpreted as further rate cuts, provided as an economy we are on track of meeting the inflation targets which the RBI has set. Further, the macro-economic situation of India is clearly showing signs of improvement, and if the Government is able to meet its fiscal deficit targets we can expect to see Government bond yields softening over the next 2 to 3 years. This augurs well for investors in both gilt funds and long term income funds. The difference between the two is that, gilt funds are more sensitive to yield shifts compared to income funds, and as such are more volatile than income funds. You can select the appropriate fund based on your risk tolerance level and investment timeframe. We have discussed different debt fund types at length in our article, Demystifying debt mutual funds.