Debt mutual funds without indexation are still a great investment bet for medium to long duration

The debt mutual funds (MFs) have been gaining scale in India driven by the massive increase in the volume of debt securities. According to AMFI, the assets under management (AUM) of debt MFs was Rs. 12.3 lakh crore at the end of-February 2023. 

Although there has been a structural alteration in investment themes, the debt MFs primarily have been investing in central government securities, corporate bonds, commercial papers (CPs), certificates of deposit (CDs), T-bills and state development loans (SDLs). The role of debt MFs in financial intermediation has also become quite significant by way of financing debt securities of government and corporates. 

For risk-averse investors looking for returns, debt MFs may be an option. The best part of going for debt MFs is that it can be redeemed any time. Investors of debt MFs have the flexibility to redeem investments to meet medical or personal exigencies. A hedge against the volatility or fluctuations of the equity market, the returns may be less volatile as compared to equity markets. The low expense ratios of certain debt MFs also make investing in MFs attractive to the investors. 

Having said that, the debt mutual fund indexation is something that makes a lot of investors interested in investing in debt MFs. The inflation-adjusted returns because of indexation reduce tax liability. To avail the indexation benefit, one needs to invest in debt MFs for three years or more. The indexation provision allows the price of the investment made at least three years ago to be adjusted for inflation. Due to this, the capital gains incurred on sale or redemption reduces, resulting in less tax payable. 

The idea behind this provision is to adjust the inflation impact on the investment value. Calculated by the cost of inflation index (CII) figures provided by the government annually, indexation is applicable only in a scenario where inflation is positive. The gain from investing in debt MFs of more than three-year-tenure is usually classified as Long-Term Capital Gain (LTCG) tax. Indexation makes debt MFs a useful fixed-income investment instrument. 

However, according to the amendment in the Finance Bill 2023 coming into effect on April 1, 2023, indexation benefit in debt MFs will be removed from April 1, 2023 onwards and debt MFs will be taxed at income tax rates in line with an individual’s income.  Therefore, investors keen to take advantage of the indexation benefits have the window till March 31, 2023 to avail of the indexation benefit. Nevertheless, the tax implication shouldn’t act as a counterpoise to the investors’ sentiment, as other advantages of debt MFs outweigh that apparent limitation. 

Most of the debt MFs come with no exit load. In addition, AMCs maintain transparency when it comes to updating the investors of the fund deployment. In a falling interest rate scenario, investors are likely to get appreciation through mark to market gains in mutual funds. Debt MFs offer multiple options across the liquidity, duration and credit spectrum, active and passive solutions. The clear differentiation of Debt MF i.e. diversified portfolio, with very high regulatory oversight, the highest disclosure standards makes Debt MFs an investment option for Retail as well as institutional investors.

With the bond yields at 7.30%-7.40% (source: Bloomberg), I believe, it may be a good opportunity to invest in medium to long duration Funds, GILT Funds, BPSUs, Debt ETFs and at the shorter end in Liquid Funds and Money Market Funds depends on the individual risk appetite.

Author: Sanjay Pawar, Fund Manager – Fixed Income, LIC Mutual Fund Asset Management Ltd