Long-term capital gains on debt mutual funds no longer qualify for indexation advantages. Debt mutual funds (MFs) will be subject to income tax based on an individual’s income starting on April 1, 2023. In the Finance Bill 2023, which was approved last week at the budget session, the government made the amendments.
Since indexation advantages are no longer available, gains on debt mutual funds now undergo debt mutual fund taxation. It is according to the individual’s tax bracket, much like fixed deposits. Prior to this, investments in the debt mutual funds held for three years or more were taxed at the LTCG rate of 20% or, without indexation, at 10%.
What Are Debt Funds?
A debt mutual fund, commonly referred to as a fixed-income fund, invests a substantial amount of your funds in fixed-income assets. This includes corporate bonds, government securities, and other money-market instruments. Debt mutual funds significantly reduce the risk element for investors by investing in such areas. This is a pretty secure investment option that could contribute to wealth creation.
Reasons to Invest in Debt Funds – Advantages
According to their unique interests, goals, and risk tolerance, investors should make a combination of investments in shares, debt, gold, and other assets. The investment portfolio becomes broader and more balanced by including debt funds with different types. Here are some benefits of debt funds that make it compelling for investors to do so:
Due to their lower reliance on market sentiment, debt funds are renowned for providing consistent returns. The best debt mutual funds allocate 65% of their corpus to less volatile debt securities than equities, such as certificates of deposits, debentures, bond papers, etc. They may not provide as significant returns as equities funds, but they also do not collapse as quickly since they are less subject to market fluctuations.
Debt funds are appropriate for cautious investors who want to maximise financial gains with the least amount of risk. They are somewhat more resistant to market volatility when investing in fixed-income assets with set maturity dates and interest rates. Therefore, combining these funds with certain equity funds in the portfolio balances the risk-return profile. When equity funds are not doing well, they serve as a buffer against market volatility.
Debt funds are simple to liquidate since you may rapidly cash them out and redeem them at any moment. It is simpler than other fixed-income investing options, such as money market accounts (FDs), which may include lock-in periods and penalties for early withdrawals. Debt funds offer high liquidity because they don’t have this kind of lock-in.
Suitable for Short-Term Goals & Emergency Funds
Debt funds are a good option for investing extra cash so you may earn income. Debt funds may be beneficial in achieving short-term objectives since they often provide greater interest rates than bank savings. Additionally, you can retain a cache of money in loan funds to build an emergency fund to handle sporadic monetary emergencies.
You have the choice to make a lump sum investment in debt funds if you have extra cash. As an alternative, you can move units between funds using STPs (Systematic move Plans) or invest modest sums using SIPs (Systematic Investment Plans).
Indexation in income tax for debt funds is a technique used to account for inflation when determining an asset’s acquisition price. Let’s look at an illustration of indexation to comprehend it better, then examine how indexation helps debt fund investors.
Impact Of Indexation Removal on Debt Mutual Funds: Moderately Negative
The following are the effects of the move on debt mutual funds, according to CLSA:
- As a result, the MF industry’s non-liquid debt AUMs of about Rs. 8 trillion (19% of AUMs) lose some of their relative allure due to tax arbitrage.
- The Rs 6.6 trillion in liquid mutual funds (MFs) won’t be much impacted because they are already short-term investments, and the tax environment hasn’t changed significantly.
- The non-liquid loan product revenue contribution ranges from 11–14%. Since equities AUMs account for the majority of AMCs’ income and profitability and non-liquid loan AUMs are neither a category with higher growth potential nor one with higher profitability potential, brokerage company CLSA feels that this has a moderate to low impact.
Positive Impact for Banks
Tax arbitrage vs bank deposits is no longer possible with the planned modifications (which have not yet been enacted as a bill) for debt MFs. People who invested in debt funds in order to gain from indexation may now switch to bank deposits because FDs have the added benefit of being free of interest rate risk. It has a favourable effect on the bank, but the amount cannot be very significant because the market for bank deposits is worth Rs 180 trillion, but the market for all debt from MFs is only Rs 8 trillion.
According to experts, the new regulation would significantly affect debt mutual funds. Investors may switch from debt funds to equity funds if they lose interest in debt funds. As an alternative, funds may be allocated to the debt category’s non-convertible debentures, sovereign gold bonds, and bank fixed deposits.
Your portfolio may be diversified and stabilised by using debt funds, which produce consistent returns from fixed-income assets. Both novice investors and those with modest risk appetites can use them since they balance out market volatility. Additionally, because they are so simple to redeem, you may use them to create emergency reserve money. You can also spend them when you need immediate liquidity.