FundsIndia Debt Strategy – Post Budget

In a move that could disturb the tax efficient structure of some of your debt mutual funds, the Union Budget 2014 has proposed changes to the way your non-equity mutual fund gains will be taxed. Besides, there is also a less significant change – in terms of calculating the dividend distribution tax for debt mutual funds. We will look at the second one, through a blog post later this week.

We shall discuss how you could deal with the change in tax to ensure you continue to earn returns superior to traditional options such as fixed deposits. But first, please note that these changes are still in their proposal stage. Our advice would be for you to wait for any further changes/clarifications until the bill is passed before you decide on your course of action.

Three-year holding to qualify for indexation benefit

Thus far, all non-equity mutual funds held for more than one year qualify for indexation benefit at the time of redemption as they are treated as long term capital gains. This time frame is now increased to 36 months. That means you will have to hold these funds for three years to enjoy indexation benefits.

Non-equity funds include all categories of open-ended and closed-end debt funds, debt-oriented funds such as MIPs, FMPs, international funds, gold funds and other hybrid funds and fund-of-funds.

Besides, currently the tax on debt mutual funds is 10% without indexation, or 20% with indexation. The 10% option is proposed to be withdrawn. You will still have the 20% with indexation option.

This change is effective for sale or redemption of funds from the current financial year. Unless there is any change or clarification issued by the Income Tax Department, this proposal will be applicable for the financial year beginning April 1, 2014.

Now, what is the implication for the various debt fund categories if this proposal is to be passed?

– If you have been investing in liquid or ultra short-term funds with a less than 1 year view, nothing changes as the tax status of ‘short-term capital gain’ remains.
– For those of you investing in debt income funds as a part of your asset allocation for the long term (over 3 years), no harm done, as you will continue to benefit from indexation. In fact, inflation indexation in the last 3 years was so high (9.2% annualised) that you would have paid almost nil tax on most of your debt fund investments.
– Similarly, for those buying gold funds or international funds, we have maintained that these asset classes require an at least three-year time frame as they are either part of your asset allocation or diversification strategy. Hence, in our view, your strategy to these categories of funds should remain neutral.

Then where would you have to tweak your strategy?

FMPs to lose sheen

If you are an avid FMP investor, especially in the 1-3 year bucket, then you have to only keep your fingers crossed about an FMP’s ability to deliver returns superior to traditional debt options, stripped off the tax advantage.

Of course, it is possible for FMPs to go for instruments (perhaps with slightly higher credit risk) to still deliver enhanced returns to you; but then if your purpose of investing in FMPs would be to assume minimum risk and generate FD-beating returns, then it may be a tough call to invest in this segment.

Added to this, as things stand, had you invested in FMPs believing that you will get ‘double indexation’ benefit, the proposal in its current form will deny you that. Hence, FMPs in the less than 3-year time frame run the risk of going into oblivion.

Short-term debt fund strategy now

Besides FMPs, those of you who invested in short to medium term open-ended debt funds with a 1-3 time frame would need to be aware of the loss of indexation benefit. What should be your strategy at this juncture if you are invested in this time frame?

If you have at least 1 more year to go for your goal, then there are good chances for these short-term debt funds to participate in a price rally when rates fall. Hence, even if you have to pay tax at your income slab, chances are that their returns would be superior to FDs.

Hence, if you have a 1-2 year time frame, irrespective of whether your investment touches 3 years or not, you can adopt a hold strategy. This holds true for investors entering this category with a view of the next 1-2 years.

Having said that, once rates fall, it may be hard for this category of funds to consistently beat traditional options on a post-tax basis. Hence, we provide some alternatives, strictly not like-to-like, if a tax-efficient structure and generating superior returns are your primary goals.

Alternative options for investors

The first option is arbitrage funds. These funds, in reality, are equity funds but are fully hedged with derivative positions in all the stocks they hold. Their return opportunity comes from any arbitrage in the cash and derivatives market.

Such arbitrage is high in a volatile market and low in a market that moves in a single direction. The key thing here is that these funds cannot generate equity returns given the neutralising positions they hold in derivatives.

But it also means that they cannot fall like equities. Hence, as a segment, they can be expected to generate money market plus returns, and they come with a low risk profile – that is low risk of capital loss (technically there should be none).

These products have a low exit load period, and have no dividend distribution tax (as they are considered as equity) and no capital gains tax if held for more than 1 year. This makes them an attractive option for those who are keen to keep their tax holding efficient.

Our picks in this segment would be ICICI Pru Equity Arbitrage, IDFC Arbitrage and SBI Arbitrage Opportunities. These funds have delivered in the range of 9.4-9.8% in the last 1 year.

Look out for a detailed coverage on arbitrage funds and how they work in the following weeks. But please make sure you understand this product well before you choose to invest in it.

Our next strategy for those mostly with a 2-3 year time frame would be to invest in MIPs/debt-oriented funds. Now you might ask why as these funds too would have to be held for 3 years to enjoy indexation benefits.

Our suggestion here is based on the fact that these funds can generate debt-plus returns over 2-3 years. Therefore, even if you end up paying full taxes, their returns could be marginally higher than FD returns. But these are strictly for those with a higher risk appetite given the 20-25% equity component. Also, investors in the 10-20% tax bracket may prefer this option.

Please check our Select Funds (categorised as hybrid funds–low risk) for MIPs/debt-oriented funds.

But in all this remember the following:
– Do not act until the proposal is passed as a bill.
– Always check post- tax returns when comparing with traditional debt products. A back of the envelope calculation would be that a 9% FD would deliver a return of 6.3% post tax (with compounding, in a cumulative option, it would be about 6.6%) over 3 years.
– All your debt funds earn returns every single day while the interest compounding is quarterly with deposits.

Do talk to our advisors if you need help reviewing your debt portfolio.