Debt funds vs arbitrage funds: How to pick the right one for short-term goals

Debt funds and arbitrage funds are two popular low-risk mutual fund options for parking money for short to medium terms. Both aim to deliver steady returns with lower risk than equity funds, but they work differently.

Debt funds invest mainly in fixed-income instruments like government securities, corporate bonds, and money market instruments.

Arbitrage funds, on the other hand, aim to earn from price differences in the cash and futures markets. They use a hedged strategy and are taxed like equity funds.

Here’s what experts say about when to choose each.

Who should pick debt funds?

“Debt funds offer a wide range of options for different needs,” says Piyush Baranwal, Senior Fund Manager, WhiteOak Capital MF.

Investors with low risk appetite who want to park money for a few weeks to a few years can find suitable options within debt funds.

Liquid funds work for very short-term parking, while ultra-short, short-duration or corporate bond funds can fit goals spanning a few months to a few years.

Debt funds usually stick to conservative credit risk and focus on stable income through accrual strategies. They suit investors using Systematic Transfer Plans (STP) or Systematic Withdrawal Plans (SWP). A recent tax rebate under the new regime also helps.

“For investors in lower tax brackets, income up to ₹12 lakh, including from debt funds, can potentially be tax-free due to Section 87A,” says Baranwal.

Anand K Rathi, co-founder of MIRA Money, adds, “Debt funds are great if you want your money to grow reliably, nothing fancy.”

Who should pick arbitrage funds?

Arbitrage funds behave like debt funds but are taxed like equity. This helps high-income investors lower tax outgo.

“Arbitrage funds work best for investors in the highest tax bracket, planning to invest for a few months to over a year,” says Baranwal.

Rathi explains, “They aren’t meant for 30-day parking. But if you don’t touch the money for six months or more, they save taxes and deliver steady returns.”

Swapnil Aggarwal, Director, VSRK Capital, says arbitrage funds suit ultra-conservative investors who want FD-like safety with tax efficiency.

How to choose between liquid, short-term debt and arbitrage?

Pick based on your time horizon. “For parking money for a few days to months, choose liquid funds. For a few months to a year, ultra-short or money market funds fit well. If you have a year or more, short-duration or corporate bond funds make sense,” says Baranwal.

“Arbitrage funds appeal to high tax bracket investors investing for a month or more. On a gross return basis, debt funds often compare well, but arbitrage’s tax treatment gives them an edge for the highest earners,” he adds.

Rathi breaks it down simply: “Think of liquid funds as your smarter savings account. For flexible short-term parking, go with liquid or short-term debt. Arbitrage works if you want to save taxes and can hold for at least six months.”

How have these funds done lately?

Debt funds have benefited from India’s easing rate cycle. “Short and medium-term debt funds did well as falling yields boosted returns,” says Baranwal. But very long-term bonds didn’t gain as much due to demand-supply gaps.

Arbitrage funds stayed competitive too.

“Liquid funds gave just under 7% returns. Arbitrage funds hovered around 6.7% and saw big inflows for better post-tax returns,” says Rathi.

Aggarwal adds, “Liquid, money market and short-duration debt funds delivered 6-7% annualised. Arbitrage funds clocked 6-6.5% annualised, sometimes outperforming liquid funds post-tax.”

Is mix a good idea?

Combining both can help balance liquidity and tax benefits.

“Blending arbitrage and short-term debt funds gives SIP investors stable returns, liquidity and tax efficiency,” says Aggarwal.

Rathi agrees: “It’s like a safety net. Meet short-term needs with debt, let arbitrage run longer for tax savings.”

Common mistakes to avoid

Experts warn against chasing past returns or ignoring tax impact. “Some investors forget arbitrage funds aren’t as liquid—redemption is T+2, versus T+1 for debt funds,” says Baranwal.

Rathi cautions, “Don’t treat arbitrage like an FD. It wobbles short term. Match your holding period to the fund.” Aggarwal notes, “Many overlook the holding period and assume guaranteed returns. Debt funds carry credit and interest rate risks too.”

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