The curious case of debt funds Despite losing out on indexation benefit in the amended Finance Bill, debt funds still add value to the client and have advantages that other investment avenues may not, say industry experts

Consider this: Between April 2019 and March 2023, more than 22 lakh folios were added in the open-ended schemes of debt mutual funds, which is a whopping increase of 38%. This increase and rise in the popularity of debt funds was mainly on account of taxation benefits enjoyed by them over the years.

But the recent amendments to the finance bill has taken the sheen off them and has left many investors in the lurch. As per the amended Finance Bill, capital gains on debt mutual funds (whether short-term or long-term capital gains) will now be added to one's income and taxed according to one's tax slab. There will not be any indexation benefit. The latter allowed one to inflate the purchase price. So when you sell your fund at a later date, you may end up paying lower tax on debt mutual funds. This benefit was only in the debt fund category.

Say you invested INR 5 lakh in a short-duration fund (debt fund) in 2019, which grew at 7% per year, it would be worth INR 6.55 lakh in four years. Under the new rules, however, a person in the 30% tax bracket will pay around INR 46,000 in taxes, while with indexation, it would have been approximately INR 12,000. Following this announcement, mutual fund houses saw a strong rush from investors to park their money in debt funds to lock into the indexation benefits.

Says Mahesh Patil, Chief Investment Officer, Aditya Birla Sun life Mutual Fund. "We saw debt funds getting strong inflows in the last week of March to benefit from the long term capital gains and indexation. Funds were received across categories both actively managed funds like corporate bond fund, long duration funds, gilt funds and also into passively managed target maturity funds."

"The removal of the long-term capital gains tax on debt funds came as a surprise to many investors, and some of them took advantage of opportunity to invest heavily in debt mutual funds before the window closed on March 31, 2023. Investors were keen to capitalize on the high yields available, and many opted for longer-term target maturity funds as a way of locking in those elevated returns." says Niranjan Avasthi, SVP & Head-Product, Marketing and Digital, Edelweiss Mutual Fund.

But the big question is: would this rush continue with the changes brought in by the finance bill? Industry is positive on this. Says Sandeep Yadav, Head, Fixed Income, DSP Mutual Fund, "In the past two decades I have seen many regulations regulating products in the financial markets. Initially it seemed that the regulations would be detrimental to those products, but more often than not these products have bounced back quickly. Products that gave value to the client thrived even if the final value was reduced. Debt funds still add value to the client and have benefits that other investment avenues may not. Thus, while there may be some initial impact, debt funds would recover soon."

Patil seconds his opinion, "We believe that tax benefits were just the icing on the cake for debt funds and the cake is still being relished. There are many benefits of debt funds over and above tax saving."

At par with FDs?

Although there are similarities between debt funds and bank fixed deposits (FDs), it is not entirely accurate to say they are at par with each other. Each investment option has distinct features that make them suitable for different investor needs.

No prepayment penalty, easier exit

Unlike FDs, returns in debt MFs are independent of the period you are investing. Also, there is little or no prepayment penalty unlike in FDs. "Despite the tax regulations making debt funds less enticing, they still provide one of the best debt investment solutions. Unlike some other investment channels, debt fund investors are usually not locked in and can exit the funds when they make capital gains," says Yadav.

Good tax deferred vehicle

Debt funds are more than a tax saving tool. In fact they are good tax deferred vehicles. If you invest in a debt fund and hold it for 10 years, you do not pay any taxes for the first 10 years. In case of FDs, the bank deducts TDS.

Actively managed

Debt funds are actively managed and they endeavor to provide higher returns owing to two aspects – potentially better yields of the underlying debt instrument and price appreciation of these instruments, if any.

Lower reinvestment risks

With debt mutual funds, the reinvestment of coupons is done by the funds themselves, eliminating the need for investors to worry about reinvestment risks. This process also happens in a more tax-efficient manner, reducing the likelihood of any leakage in terms of inflows.

What should investors do?

The fund managers advise investors to stay invested in debt funds. "We advise investors to remain invested in debt funds (and not time the investment), and put themselves in a position to make gains whenever the sharp rallies occur," says Yadav.

"The yields have become attractive across maturity and we believe investors should consider investing in fixed income," says Patil.

"While rates have retraced from the peaks, we believe that the rally in debt markets has more legs. The risk of yields rising is much lower right now. The rate hikes usually take a few quarters to impact the real economy. We can see the impact in the economy currently. The worst of inflation is behind us, and the risk of growth falling is ahead of us. Systemic risks on banks have appeared out of nowhere. Thus, in such a scenario where yields may not rise, worsening data could lead to a sharp fall in yields," adds Yadav.

Long term funds look good

According to Gaurav Sharma, Vice President, Client Advisory, Indmoney, debt funds would still remain a preferred choice for short-term parking of the money as well as for investors who want to speculate over interest rate movement.

"RBI has increased interest rates six times to control inflation before the latest pause. So, long-term debt funds such as gilt funds and dynamic bond funds might get some benefits from a pause in interest rate hikes. Since these funds typically invest in government securities, corporate bonds, and debentures that have higher than 5-7 years of maturity. When interest rates remain flat or are cut, these long-duration funds become more attractive to investors, and the prices of such instruments usually increase," says Sharma.

Another category to look at is credit risk funds. They invest in risky, low-rated bonds. "When interest rates are not rising (pause or cut), the cost of borrowing for low rated companies might also remain the same or fall, so these companies can easily manage to pay their debt or raise more money. If someone can take a bit of a risk, they can look at credit risk funds also," adds Sharma.