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Should you continue to invest in debt funds after the tax change?



Mutual fund investors may have been unpleasantly surprised by a recent tax change for non-equity funds. The Finance Bill amendment, effective as of April 1, 2023, states that all capital gains in non-equity funds, regardless of their length, will be taxed based on the investor's income tax rate. Previously, long-term capital gains in debt funds held for 36 months or longer were taxed at a rate of 20% after factoring in indexation benefits. However, starting on April 1, 2023, all capital gains in debt funds will be included in the investor's income and taxed at their marginal tax rate, which is determined by their income tax slab.


The recent tax change by the Finance Minister has eliminated the long-term capital gains (LTCG) tax benefit for debt funds, making their taxation equivalent to that of bank fixed deposits and some government small savings schemes. With this change, some investors are questioning the value of investing in debt funds, as they no longer have a tax advantage. Many have criticized the decision to remove the LTCG benefit, claiming that it is unfair to treat a market-linked investment product in the same way as virtually risk-free investments.


However, it is important not to make hasty conclusions. Were investors solely investing in debt mutual funds for tax benefits? What are the other benefits of investing in debt funds? Investors should consider factors such as diversification, liquidity, and potentially higher returns compared to fixed deposits, which may make debt funds a viable option for their investment portfolio despite the change in tax structure. Therefore, it is essential to assess one's investment objectives and risk appetite before deciding whether or not to invest in debt mutual funds.


Even though debt funds no longer enjoy tax advantage over traditional fixed income investments like Bank FDs, Government Small Savings Schemes etc., we think debt funds continue to be good investment options for investors.


Firstly, debt funds invest in debt and money market instruments with the aim to generate better than risk-free returns. Historical data shows that S&P India Bond Index (composite index of Government and corporate bonds) despite higher volatility has given better returns than traditional fixed income investments over multiple interest rate cycles (see the chart below). Historical data shows that S&P India Bond Index despite higher volatility has given better returns than traditional fixed income investments over multiple interest rate cycles.



Source: BSE, SBI, Advisorkhoj Research. SBI average 1 year FD interest rates over the investment tenure have been assumed to be a proxy for Bank FDs. Period: 01.04.2013 to 31.03.2023. Disclaimer: Past performance may or may not be sustained in the future.

Secondly, debt funds offer potential capital appreciation in favorable interest scenarios. Debt mutual funds can have two sources of returns – income and capital appreciation. Income is the yield of the bond i.e. the coupon or interest paid by the bond divided by its price. Capital appreciation is the change in price of the bond. Bond prices are inversely related to interest rate changes. Bond prices and debt fund Net Asset Values (NAVs) go up when yields or interest rates fall and vice versa. For the sake of investor awareness, we must mention here that the change in bond price due to interest rate changes can be a double edged sword. While you get the benefit of capital appreciation in a favorable interest rate scenario, you may also see a decline in NAV if interest rate change is unfavorable.


Finally, unlike Bank FDs, there is no taxation / TDS on debt funds during the investment tenure, in other words, compounding benefits will be higher in debt funds.


Conclusion

The change in LTCG taxation of debt funds would have caused disappointment to many investors. But you should not act in haste. You will continue to get Long Term Capital Gains Tax benefit of indexation for all investments made before 1st April 2023. Even for your fixed income investments going forward, debt funds can be suitable investment solutions. You should consult with your financial advisor to discuss which debt funds may be suitable for your investment needs.

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