The regulations have changed for debt-oriented mutual funds starting April 1, 2023. It’s been over a month since the Finance Bill 2023, recently passed in the Lok Sabha, classifies income from debt funds as a short-term capital gain.
Before that, debt funds enjoyed a lower effective long-term capital gains tax rate. NAV gains were taxed at only a 20% rate, along with indexation benefits for investments held for three years or more. Indexation benefit effectively reduced the net gain by adjusting the cost with the prevailing inflation rate.
The new regulation has done away with this tax advantage and puts debt funds on par with Bank Fixed Deposits (FD) in terms of taxation.
However, there are still reasons for investors to prefer debt mutual funds over Bank FDs:
When an investor allocates money to an emergency fund, liquidity is paramount. How fast can they access money without compromising on returns or the safety of capital?
In this regard, liquid, floating rate and short-duration debt funds continue to score over that of Bank FDs. In addition, liquid funds are usually available for withdrawal a day after making the redemption request, while bank FDs typically have a penalty levied for premature withdrawal.
Thus, investors seeking the flexibility of liquidity access would prefer short-term debt funds over bank FDs.
Debt funds invest in high-rated corporate papers, sovereign bonds, commercial papers, certificates of deposits, and treasury bills.
While the returns of a debt fund and Bank FD depend on the economy’s interest rate situation, there are opportunities for debt fund investors to earn a bit more. For instance, debt funds can improve their portfolio yields by taking calibrated exposure to corporate bonds of different credit profiles.
The highest quality corporate debt papers with a maturity profile between 3-5 years yield about 7.50% annually. By diversifying their bets, they also can manage risk better.
In addition, the debt fund portfolio is marked-to-market. Therefore, it allows them to improve their NAV whenever interest rates fall in the bond market (and vice versa). For instance, a debt fund with an average maturity of 2 years could add 2% returns to its NAV when interest rates in the economy fall by 1%.
Interest rates are currently high and expected to remain elevated as RBI remains concerned about the stickiness of the core inflation in the economy. However, with the interest rate nearing its peak, it’s more likely that RBI would start cutting rates on seeing evidence of inflation under control.
A staggered duration exposure by debt funds can generate capital gains whenever RBI starts lowering Repo rates. In contrast, a lower interest rate could only lead to a downward revision of coupon rates on bank FDs.
Set-off capital gains
Interest income earned on the bank FDs is taxable at the marginal rate every financial year. For example, consider an investor in the highest income tax bracket (30%) with an interest income of Rs 50,000 in a financial year. Her annual interest income over Rs 40,000 will be taxed at 30%.
On the other hand, capital gains of debt funds are taxed only at the time of redemption. While the entire NAV gains would be taxed at the marginal rate, they can also be set off against capital losses, if any.
Moreover, there would be a 10% TDS on interest income of more than Rs 40,000 in a single financial year for the bank FDs. In contrast, capital gains of debt fund investments are not subject to any TDS.
Last but not least, while regulations have changed for debt funds, investments made before 31st March 2023, for 36 or more months, will continue to benefit from indexation and the flat 20% tax rate. Therefore, investors can continue to hold their debt fund investments without worrying about higher tax implications.
Despite losing tax advantage, debt funds continue to score over bank FDs regarding liquidity and portfolio diversification. Moreover, through calibrated corporate exposure and its ability to benefit from a fall in interest rates, they offer a better potential to earn higher returns.