Two years ago on Wednesday, 20th January 2010, the BSE-Sensex closed at 17,051.

On Friday 21st January 2012, the Sensex closed at 16,739.

In the last 2 years, the Sensex has effectively moved sideways and experienced range bound volatility along the way.

Long term, savvy investors have taken any dips as opportunities to buy equities both directly and via mutual funds and will wait for the markets to recover to make their gains in equity. But what about the gains to be had from debt?

In its zeal to battle soaring inflation, the Reserve Bank Of India (RBI) hiked the repo rate (the rate at which the RBI lends funds to the system) by 375 basis points since March 2010 bringing us to the peak of the interest rate cycle today. Going forward, we can expect liquidity to be slowly eased into the economy to boost growth, and when that happens debt funds can start significantly contributing to your wealth building process.

The rule with debt funds is simple. When yields fall, prices rise, and vice versa. As the RBI cuts rates and interest rates start to go down across the board, investments in debt mutual funds will start to make money as prices of these instruments go up. If your portfolio is diversified across the asset classes (equity, debt, property and gold), and the debt component of your portfolio is geared for gains, then the coming year will go very smoothly on the debt side.

There are 2 main things you need to know when considering debt investments:

1. If a life goal is less than 3 years away, invest in debt.
   At the heart of every investment is a reason for making the investment. You have invested not just to become rich, but to use that wealth for a purpose - maybe your retirement, your child's education, purchasing another property, or any other life goal you might have. These goals will have different tenures – your retirement might be farthest away, while purchasing another property might be in the next 2 years. For a short term goal i.e. less than 3 years away, exposure to equity market volatility is not advisable. For goals of these tenures, capital protection is a must, with safe returns. Debt instruments are the way to go.
   
   
2. Diversify within debt
   
   Before investing in debt, ask yourself the following questions:
   1. What are your liquidity needs?
   2. What is your investment time horizon?
   3. What level of debt-related volatility can you handle with commensurate returns?
   4. What is your post tax return going to be?

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.