The curious case of debt funds

Take a look at this: between April 2019 and March 20, 2023, over 22 lakh folios have been added to the open-ended debt mutual fund schemes, which represents a 38% increase. The tax benefits that debt funds have enjoyed over the years are a major reason for their popularity.

The recent amendments made to the Finance Bill have taken away the shine and left many investors scrambling. According to the Finance Bill amended, capital gains from debt mutual funds will be added to your income and taxed based on your tax bracket. No indexation benefits will be available. This allowed for an inflation of the purchase price. You may pay less tax if you decide to sell the fund later. This benefit only applied to debt funds.

If you invest INR 5 lakh (debt fund), which grows at 7% annually, in 2019, it will be worth INR 655 lakh after four years. According to the new rules, someone in the 30% bracket would pay approximately INR 46,000 as taxes. With indexation however, the amount would be INR 12,000 Mutual fund houses experienced a rush of investors who parked their money into debt funds in order to take advantage of the indexation benefits.

"We saw strong inflows into debt funds in the last weeks of March, as they benefited from long-term capital gains and indexation. The funds were received in a variety of categories, including actively managed funds such as corporate bond funds, long-duration funds, gilt funds, and passively managed target maturities funds.

The removal of long-term capital gain tax from debt funds surprised many investors. Some of them invested heavily in debt mutual fund before the window ended on March 31, 2023. Many investors were eager to take advantage of the high returns available and chose longer-term target maturities funds in order to lock in these elevated returns. Niranjan Avasthi is SVP & Head of Product, Marketing & Digital at Edelweiss Mutual Fund.

The big question now is, will this rush continue after the Finance Bill? The industry is optimistic about this. Sandeep Yadav is the Head of Fixed Income at DSP Mutual Fund. "In the last two decades, I have seen a lot of regulations that regulate products on the financial market. At first, it appeared that regulations would harm these products. However, in most cases they have rebounded quickly. Even though the value of the product was reduced, products that added value to clients thrived. Debt funds are still beneficial to clients and offer benefits other investment avenues do not. While there may be an initial impact on debt funds, they would recover quickly."

Patil confirms his statement: "We think that tax benefits are just the icing of the cake, and we still enjoy the cake." Debt funds offer many other benefits than tax savings.

Are FDs on par with FDs

While there are some similarities between bank fixed deposit (FDs) and debt funds, it would be inaccurate to say that they are on par. Each investment option is unique and has features that suit different investor requirements.

Easy exit with no prepayment penalty

Unlike FDs the returns on debt MFs do not depend on how long you invest. There is also little or no penalty for prepayment, unlike FDs. Despite tax regulations that make debt funds less attractive, they are still one of the most effective debt investment options. Debt fund investors can usually exit funds if they have capital gains, unlike some other investment channels.

Tax deferred Good Vehicle

Debt funds offer more than just tax savings. They are good vehicles for deferring taxes. You will not have to pay taxes in the first 10 year if you invest and hold a debt fund. The bank will deduct TDS from FDs.

Actively Managed

The debt funds actively manage and strive to achieve higher returns due to two factors - the potential for better yields on the underlying instrument of debt and any price appreciation.

Lower reinvestment risks

The funds themselves reinvest coupons, so investors don't have to worry about the risks of reinvestment. This process is also more tax efficient, which reduces the risk of leakage of funds.

What should investors be doing?

Fund managers encourage investors to remain invested in debt funds. "We recommend investors remain invested in debt fund (and not to time the investment), to put themselves in position to gain whenever sharp rallies happen," says Yadav.

Patil says, "We believe that fixed income investments are a good option for investors because the yields are attractive."

"While rates have retraced, we believe the rally on the debt markets has more leg. The current risk of rising yields is lower. Rate hikes typically take several quarters before they have an impact on the real economy. We are already seeing the effects in the economy. We are now past the worst of the inflation, but we still face a risk of a slowing economy. The systemic risks to banks are now a reality. In a scenario in which yields are unlikely to rise, deteriorating data may lead to a sharp drop in yields." adds Yadav.

Long-term investments look good

Gaurav Sharma is Vice President of Client Advisory at Indmoney. He says that debt funds will remain a popular choice for investors looking to park their money for a short period and for those who wish to speculate on interest rate movements.

The RBI has raised interest rates six time to control inflation prior to the most recent pause. A pause in rate hikes could benefit long-term bond funds, such as gilt funds or dynamic bond funds. These funds invest in government bonds, corporate bonds and debentures with a maturity of more than 5-7 year. These long-term funds are more attractive to investors when interest rates are flat or reduced. Prices of these instruments will usually rise.

Credit risk funds are another category worth considering. They invest in low-rated, risky bonds. When interest rates do not rise (pause or reduce), the cost to borrow for low-rated companies may also stay the same or even fall. These companies will be able to easily pay off their debts or raise additional money. "If someone is willing to take some risk, then they should also consider credit risk funds," says Sharma.