Have debt funds lost their lustre after govt pulled tax incentives?

As investors, managers adjust their return expectations, so will bond prices, as roughly 30% of mutual fund AuM (assets under management) in debt funds resets

In a continuing trend, the government pulled long-term capital gains (LTCG) from high value insurance policies, then market linked debentures and then, in a late surprise move, debt funds. Now all these categories will be taxed at income tax rates rather than any other head. The ostensible reason was it neither encouraged savings nor was the retail investor benefiting from sops.

Debt funds or those mutual funds which invest in bonds issued by the central government, private companies, state governments, government owned companies (PSUs’) were affected when the LTCG levy went from 10 per cent (or 20 per cent with indexation) to the tax applicable to their salaries. Furthermore, the rules came into effect on April 1, leading to frenzied buying right up to March 31. And since then, a cancelled NFO (new fund offer), lowered flows as investors recalibrated their portfolios.

Also Read | Employers to ask employees about preferred tax regime for deducting TDS from salary: CBDT

But is it all gloom and doom? After all if (on average) the taxes take a third of your returns, a 7.5 per cent yield fund falls below even current inflation. And what about fixed deposits (FDs)? First FD taxation – this is always paid on accrued interest, there is a TDS on payment and a certificate is required at the end of the fiscal year with the accrued interest added to your earnings for taxation. A debt fund or ETF is still a capital gain. Therefore, one does not pay anything unless there is a realised profit. The benefit? Compounding. The tax not paid periodically compounds thereby improving the overall returns even though all gains are still taxed at the same rate as an FD.

But this also means there are two categories of investors for whom nothing changes. The first is those with lower wages. While earlier LTCG was applicable, those with pay below Rs 9 lakh are unlikely to see a significant impact, especially if RBI reduces interest leading to higher returns.

Those in other income slabs and even companies which were using debt funds for short term diversified investment strategies are unlikely to see any change as they were paying income (marginal) tax rates anyway.

This leaves a lot of us, who aren’t in either of these categories, wondering whether an investment is feasible and why? Firstly, bonds provide simplest diversification in an otherwise equity-heavy portfolio, which is better than holding onto cash.

Secondly, if an investor understands bond markets, or can hold it to maturity, bonds or debentures provide long term capital gains benefit after a year even though the regular coupon payment (like interest) is still taxed at higher rates. This is quite useful when there is an expectation of interest falling over the investment horizon.

Thirdly, net of tax, lower returns may make these investments unpopular as we have seen from bond fund flows in April 2023 so far. As demand falls, yields will shift upwards (as there are more sellers than buyers), adjusting to a point where the yield (or returns) post tax still makes sense for investors.

As investors, managers adjust their return expectations, so will bond prices, as roughly 30 per cent of mutual fund AuM (assets under management) in debt funds resets. Having said that, there may be some short-term slowdown - this would be giving investors an opportunity to rebalance their portfolios. Bonds (a form of borrowing) have been around for a while and are not going away anytime soon, being one of the key ways the government and indeed corporates raise money to run the country/company and will continue to do so.

(The writer is partner at Infinity Alternatives)