With the latest budget announcement and the previous year’s budget directive, debt mutual funds have become unattractive and have been relegated to the back burner – a booming segment that has virtually been left to its own devices.
This was also gleaned when the Mutual Funds Association of India released a six-point budget report on July 30, asking the Finance Ministry to review some of the decisions, mainly those related to the future of debt mutual funds. These include restoration of indexation benefits for debt mutual funds and extension of grandfathering provision relating to these benefits.
Let us take a deeper look at using debt mutual funds as an investment vehicle in a portfolio.
For an investor building a portfolio based on his asset allocation and risk tolerance, debt mutual funds are an easy way to access bond markets without the hassle of deciding which bonds or listed debentures to invest in. There are some key flexibilities that debt mutual funds offer in constructing portfolios based on asset allocation.
-The objective of the debt fund allows the investor to choose and balance between duration and accrual strategy, effectively accessing interest rate and credit cycles.
-These funds help create a classification of investments over time based on liquidity requirements and financial objectives.
– Reinvestment risk is best managed through debt mutual funds. Coupon payments and maturities of a bond portfolio in a debt fund are reinvested, whereas in listed bonds from a single issuer, the coupon interest is realized and maturities must be reinvested by the investor.
-Asset allocation has the benefit of protecting the overall portfolio from extreme stock market volatility in order to weather economic, business and market cycles.
Slow Venture Capital
While it may be suggested that a fixed deposit in a bank is a debt-based option, it must be kept in mind that banks take time to reset their rates. And the timeframes for getting better fixed deposit rates vary, depending on the asset and liability management of the bank. So, do you open multiple fixed deposits in multiple banks?
The question we need to consider is what will happen when returns on capital are low?
To find out, we picked three years of low equity returns between 2016 and 2018 and compared them with debt mutual funds. As shown in those times, debt mutual funds, both duration and accumulation strategies in an investor’s portfolio, will help tide over the phase of low equity returns. The benefit of asset allocation is clearly seen in helping one navigate through the difficult years by aligning with one’s risk profile.
Budget disconnect: listed bonds and debentures versus debt mutual funds
According to the latest budget, listed bonds with a holding period of 12 months or more will attract a long-term capital gains tax rate of 12.5%. The short-term capital gains tax rate has been revised to 20% from the flat rate.
Debt mutual funds, a publicly traded investment vehicle holding a portfolio of predominantly listed bonds/debentures, will not be subject to the capital gains tax structure and only flat rates will apply.
From an investor’s perspective regarding ease of access to bonds/debentures for his/her portfolio, a debt mutual fund is convenient, flexible and much more risk-adjusted than a single-issuer bond/debenture.
Expecting an investor to independently choose a few listed bonds from a single higher-yielding issuer from among many bond and debenture options with limited due diligence and build a debt allocation (thereby creating higher concentration risk, credit risk and liquidity risk in their portfolio) is asking for trouble.
In short, an investor seeking to achieve his or her financial goals within his or her risk tolerance also needs to evaluate potential returns after reviewing the tax structure applicable to that asset class.
Since no exemption has been announced for investments in debt mutual funds and indexation (to adjust for inflation) has been removed across the board, all investments in debt mutual funds made before March 31, 2023, face a higher tax outlay at the time of redemption. This disrupts an investor’s planning when it comes to taking medium- and long-term positions in asset classes or investment vehicles.
A debt mutual fund with a level playing field on tax impact, as requested by AMFI for reconsideration, will help investors effectively navigate any anemic phase of equity returns in their wealth journey along with other uncorrelated asset classes.
Indian stocks may not have a linear and unidirectional upward trend forever. And prudence always suggests diversifying across efficient asset classes to weather such times.
Dennis Gabriel, Partner at Upwisery Private Wealth
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