With the latest budget announcement and the directive from the previous year’s budget, debt mutual funds have become unattractive and have been relegated to the sidelines – a burgeoning segment almost thrown under the bus.
This was also inferred when the Association of Mutual Funds of India put out six-point budget feedback on 30 July, requesting the finance ministry to revisit some of the decisions, mainly pertaining to the future of debt mutual funds. They include restoration of indexation benefits for debt mutual funds and extension of the grandfathering provision pertaining to these benefits.
Let’s dwell into the use of debt mutual funds as an investment vehicle in a portfolio.
For an investor constructing a portfolio as per their asset allocation and risk appetite, debt mutual funds are an easy way to access the bond markets without the hassle of figuring out which listed bonds/debentures to invest in. There are some key flexibilities that debt mutual funds offer in portfolio construction on the basis of asset allocation.
-The debt fund’s objective allows an investor to choose and balance between duration and accrual strategy, accessing the interest rate and credit cycles effectively.
-Such funds help build bucketing of investments across tenures based on liquidity requirements and financial goals.
-Reinvestment risk is managed better through debt mutual funds. Coupon payments and maturities across a bond portfolio in a debt fund get reinvested, whereas in listed single issuer bonds, the interest coupon is realised, and maturities are to be reinvested by the investor.
-Asset allocation has the benefit of cushioning the overall portfolio from extreme equity market volatility to ride through market, business and economic cycles.
Sluggish equity
While one can suggest that a bank fixed deposit is a debt-based option, one needs to appreciate that banks take time to reset their rates. And tenures for better fixed deposits rates vary, depending on a bank’s asset-liability management. So, does one open multiple fixed deposits across many banks?
The question to consider is what will happen when equity returns are sluggish?
To find out, we picked out three years of low equity returns in 2016-2018 and compared them with debt mutual funds. As shown in such times, debt mutual funds across both duration and accrual strategies in an investor’s portfolio will help to ride the low equity returns phase. The benefit of asset allocation is clearly seen helping navigate the tough years aligning with one’s risk profile.
Budget disconnect: Listed bonds/debentures vs debt mutual funds
As per the latest budget, listed bonds with a holding period of 12 months or more will have a long-term capital gains tax rate of 12.5%. The short-term capital gains tax rate has been revised to 20% from the slab rate.
Debt mutual funds, a listed investment vehicle that holds a portfolio of listed bonds/debentures predominantly, will not fall under the capital gains tax structure and only slab rates are applicable.
From an investor’s perspective of ease of accessing bonds/debentures for their portfolio, a debt mutual fund is convenient, flexible and far more risk-adjusted than a single issuer bond/debenture.
To expect an investor to independently choose a few higher yielding listed single issuer bonds amid many bond/debenture options with limited due diligence and to construct debt allocation – resulting in increased concentration risk, credit risk and liquidity risk in their portfolio – is asking for trouble.
To sum up, an investor seeking to meet their financial goals within their risk appetite also has to evaluate potential returns after reviewing the applicable tax structure on that asset class.
With no grandfathering of debt mutual fund investments announced and indexation (to adjust for inflation) removed across the board, all debt mutual fund investments made prior to 31 March 2023 face higher tax outlay when redeemed. This disrupts an investor’s planning in taking medium to long-term positions on asset classes or investment vehicles.
A debt mutual fund with a level playing field on tax impact, as requested by AMFI for reconsideration, will help investors to effectively navigate any anaemic equity returns phase of their wealth journey along with other non-correlated asset classes.
Indian equities may not have a linear one-way-up direction forever. And, prudence always suggests diversifying across efficient asset classes to navigate such times.
Dennis Gabriel, partner, Upwisery Private Wealth
