Will debt funds start losing their sheen from this fiscal year? maybe not

The change in capital gains tax treatment on gains arising from debt mutual funds (MFs), invested on or after 1 April, will push some investors to explore alternative investment solutions. A relevant option is Alternative Investment Funds (AIFs) which are managed by marquee fund managers and offer the ability to invest in a wider range of opportunities, including high yielding debt and other avenues.

The rise of debt AIFs

In the last year, interest in the high-yielding debt AIF space has grown, as most debt MFs yielded anywhere between 3-5% gross returns due to the sharp increase in interest rates. In the same period, Consumer Price Inflation (CPI) rose higher than 6%, and left investors with a negative real return. Even for investors who were willing to allocate towards credit risk MFs, the returns were much lower than debt AIFs. MFs sharply cut down their allocations to the mid-corporate segment since 2018-19, following the IL&FS default and the Franklin Templeton debt fund crisis. As a result, the mid-market enterprises have faced a lack of access to debt, which has presented an opportunity to structured and private debt AIFs.

Debt AIFs offer an investment opportunity across multiple strategies such as structured credit, venture debt, mezzanine debt, etc., that may offer investors a gross return of 15-18%. This has driven interest towards debt AIFs in addition to their professional management, diversification offered. etc.

Investing in debt AIFs is not for the average investor though and comes with its own risks and limitations including the regulatory minimum investment of R 1 crore, catering predominantly to high net worth individuals and family offices. So, while debt AIFs may find a place in a few portfolios, what we recommend is to follow basic tenets of asset allocation while creating a fixed income portfolio.

Actively managed debt MFs are important

While taxation changes have resulted in rendering any tax arbitrage (across debt instruments) meaningless, but the grandfathering of long-term capital gains for all investments done up to 31 March is a significant measure to help carry on these gains for the next many years. MFs also offer portfolio liquidity and minimal to nil exit load, which is attractive compared to other debt products. Also, given that most of the rate hikes are behind us, we believe it’s a great opportunity to start allocating towards actively managed debt MFs. We see a two-fold benefit in doing so:

Firstly, as rates plateau, there is a limited negative impact on fund net asset values, or NAVs, (that might arise due to any future rate hikes) thus helping investors lock-in entry yields at the near peak. This helps to get an attractive carry as long as the rates remain high.

Secondly, when rates start coming off in the system (by way of policy rate cuts), managers could potentially increase modified duration of their funds, thus helping participate in marked to market gains for investments made.

A combination of both these factors could offer near double digit or higher holding period returns which are relatively cost- effective and provide liquidity at all points in time.

On a post-tax basis, the returns would continue to be attractive (as we believe the mark to market, or MTM, movement would partially offset negative tax impact). There are opportunities to invest across fund categories that align with investor risk appetite:

For conservative investors, a high credit quality accrual-oriented fund portfolio may be suitable where one might take interest rate risk but would be safeguarded against credit risk.

Balanced investors may consider a combination of duration-oriented strategies along with some allocation towards accruals.

Aggressive investors may consider a combination of 70% fixed income investments in MFs, with the balance 30% towards high yielding debt AIFs, that has the potential to create an optimal fixed income portfolio for the next 4–6 years.

While it is still early days, Sebi categorization allows AMCs to come up with funds in the “balanced hybrid” category (defined by allocation to equities varying in a band of 40-60%). These could continue to benefit from the current tax regime (LTCG at 20% with indexation for a holding period over 3 years). However, this category could prove to be volatile compared to conservative hybrid funds or pure play debt funds. An alternative could be Balanced Advantage Funds where the risk is limited to the equity exposure with 35% allocation towards fixed income.

Moving into the next fiscal year, a combination of these strategies would help optimize allocations across fixed income portfolios. To sum up, it’s not an ‘either or’ approach but an ‘and’ approach that could help investors navigate the structural shift in debt space more effectively over the coming months.

Nitin Rao is CEO, InCred Wealth