Using debt funds for income

Investment for income refers to a situation where you need to regularly withdraw a part of your investment to meet your living expenses. Generally this is done by retired people or others who don't have a real income.

When an investment is made for income rather than for accumulation, many of its key features need to be different than if you were investing just to grow your wealth. First and foremost, it needs to be predictable. When money is accumulating for use much later, then it doesn't really matter if you get somewhat higher or lower returns at different times. It doesn't even matter if you lose money for some of the time as long as gains made over other time are more to balance it out. However, when you need to make regular withdrawals, then this unevenness is not desirable.

Secondly, this predictable rate of return needs to have a rate of return that matches the inflation rate, or at least comes close to matching it. If the rate of return doesn't match inflation then your money is just losing value even when you are not using it.

Thirdly, the investment needs to be liquid. By liquid, we mean that it should not have a long lock-in period and you should be able to withdraw from it regularly (if needed, at short notice) without facing any problems or incurring any kind of a financial penalty.

As it happens, there aren't too many investment avenues that satisfy all these needs. Savers who are not too knowledgeable generally use a bank savings account for this purpose. Savings accounts score well on point number one and three above. They are certainly safe and predictable. They are also highly liquid- in fact, apart from having actual cash in your pocket, they are the most liquid form of keeping money.

However, their interest rate is low. Currently, most banks offer an interest rate of around 2.7 to 3 per cent, with a few banks offering slightly higher rates. This doesn't even come close to matching the rate of inflation that consumers face. Lying in your savings account, your money loses real value and buys less and less as time goes by.

If not the savings accounts, then the second commonly used option is fixed deposits in a bank. These typically offer a higher rate of return than savings bank accounts. Most banks currently offer 5 to 5.5 per cent for a one-year deposit, which is in most cases higher than the rate offered by savings accounts. Further, fixed deposits being a banking product, are also as safe and predictable as savings accounts.

However, they obviously score poorly on liquidity. If you need regular monthly income from fixed deposits, then you'll need to set up a cumbersome roster of FDs that are maturing every month. Alternately, you will have to transfer money from maturing FDs to savings accounts and then use that for your monthly withdrawals. Neither option is practical.

There is another alternative - Post Office Monthly Income scheme. However it comes with tenure of five years and withdrawal is allowed only after one year and that too with a penalty.

This leaves debt funds as the best option. They don't suffer from any of the above flaws. The best suited sub-type for this purpose are short-duration debt funds. The returns are fairly predictable too.

These funds also have excellent liquidity - you can withdraw your money at one day's notice at any time. And the returns compare favourably to bank fixed deposits. Debt funds also have a favourable tax treatment, whereby gains are taxed only when you redeem your investments. Further, if you hold your investments for more than three years, you can also adjust the purchase cost for inflation to reduce the tax implications.

After considering all these factors, debt funds turn out to be the best option for getting a regular income from your investments.