New debt MF taxation rule give FDs an edge, but these debt fund categories can give better return (2024)

Debt funds have long been a favorite for tax effective investments when it comes to fixed income products. However, the new taxation rule that will come into effect from April 1, 2023 will take away this advantage from most debt funds. Debt funds so far enjoyed a much lower effective taxation rate as the long-term capital gain tax on a debt fund held for 3 years or more was only 20% with indexation benefit. This indexation benefit allowed investors to inflate their initial investment at the prevailing inflation rate, which helped in reduction of the net gain significantly.

So, with the new tax rule, is this the end of debt investment especially for retail investors? Not necessarily. We tell you the impact of this taxation on various types of debt funds and compare it with FD investment and which one will work better for you.

How the new taxation rule impacts the debt fund taxation

Debt funds and equity funds typically hold 65% or more investment into debt securities or equities, respectively. As per the new tax rule, all non-equity funds with less than 35% investment into equities will no longer enjoy LTCG tax of 20% with indexation effective from April 1, 2023. This tax advantage was the primary reason why many investors preferred debt investment, which has gone now.

“It’s true that recent developments have led to Debt Funds losing some advantages over Bank FDs. In view of these developments, it is likely that the Deposit Base for banks will increase since the tax advantage that was available was an important feature in the adoption of debt funds, particularly among retail investors,” says Rinju Abraham, Vice President, Scripbox.

“This has brought the Bank FDs and Debt mutual funds at parity. Both have their own benefits and now decisions will be taken on merit rather than based on the Tax benefit,” says Vinod Singh, Chief Executive Officer & Co-Founder, Finhaat.

Which debt fund categories will benefit?
There are many hybrid funds with more than 35% investment in equities which will continue offering the tax advantage. “Following the recent developments, we anticipate that Arbitrage funds will benefit significantly. Other categories, such as Dynamic Bond, Multi Asset, and Equity Savings, will also experience renewed interest,” says Abraham.

However, all investors who were investing in debt funds may not be comfortable with these hybrid funds if these do not suit their risk profile and investment objectives. “Since these funds have specific investment objectives and underlying holdings, investor interest is not primarily influenced by the tax treatment of returns. Therefore, we do not expect a significant shift in investor perception as a result of the recent developments,” says Abraham. They may continue with debt funds despite losing the taxation advantage if it scores well on other fronts.

Where debt funds still score above FDs
Despite the loss of taxation advantage debt funds have several advantages over fixed deposit.

• Better return opportunity with debt MF: “Corporate Debt funds will always give better returns than bank FDs. Pick up good quality corporate debt funds and you will always do better. In fact, Banking & PSU Debt funds too are doing better now,” says Sanjeev Govila, founder of Hum Fauji Financial Services, a financial advisory firm.
• Savvy investors can make the most of interest rate cycle: “For a savvy investor there still lies the opportunity to pick up right Debt MFs to ride on the interest rate curve,” suggests Singh.
• Helps in managing interest rate risk: “The powerful advantage of M2M (Mark to Market) available now and for say next 3 years or so would increase returns in Debt funds as interest rates go down. On the contrary, when rates go down, bank FDs will give lower returns,” suggests Govila.
• Allowed to set off the capital gain: “Income from debt funds shall still be classified as capital gains which shall be available to be set off against any other capital loss,” says Govila.
• There is no TDS to impact the final return: “In the case of FDs, the tax is payable annually in accrual of interest whereas in debt mutual funds, liability of tax comes only on redemption,” says Govila.

Debt mutual funds vs bank fixed deposit, which works better?

Assumed cost infaltion @18% in three years, *does not include the cess

Will debt funds with more than 35% equity become new favorite?
The new taxation rule has not taken away the advantage of LTCG tax of 20% with indexation fund from non-equity funds with more than 35% investment in equities. So, there are many hybrid funds that still fulfil this criteria. “Tax efficiency in investments is a strong driver of where money goes. Right from insurance, Bonds, MFs, equity, NPS, PF and other Alternative Investments, we have seen investors prefer avenues where there is lower taxation on the returns. Given that now there is Tax benefit available in this class of MFs, a good part of long term debt MFs allocations is expected to move in these funds,” says Singh.

Those investors who are comfortable with a mix of equity in their debt investment can still find these hybrid debt funds offering an attractive combination of tax efficiency and good returns. “This is also prudent, as a component of equity in the fund has capacity to provide higher returns as well as a debt component helps in controlling any significant deterioration of the principal part of investment in case of fall in the broader equity market. In the long run, this can be one of the MFs where significant retail money can move,” says Singh.

Debt MFs or FDs: How should retail investors decide?
So, how should retail investors decide between debt funds and FD as to which works better for them? “Given that each investor has different objectives and preferences, the result of the comparison between FDs and Debt Funds will be very investor specific. Having a framework to evaluate each alternative is important,” says Abraham.

Abraham suggests “When choosing any investment product, we recommend that investors evaluate them through some filters.” He suggests that investors can look at factors such as

1.What is the return profile of the product?
2.What is the risk profile of the product?
3.Does the product give investors access to expert management?
4.Does the product have market-discovered pricing?
5.Does the product have daily pricing mechanisms?
6.Does it offer adequate liquidity?
7.How easy is it to transact?
8.Does it have favourable tax treatment?
9.Is it simple and easy to understand?
10.Is there an underlying value associated with the product?

When to go for debt MFs
While returns on debt funds will remain market driven which may appeal to many investors, there are other aspects of debt funds which may still work for certain investors. “For retail investors, now the decision will be mainly driven by their situation. For Eg: An investor who wants flexibility of liquidity access along with returns will opt for short duration Debt MFs than Bank FDs,” says Singh. If you come under the higher income tax bracket and are comfortable with higher equity exposure, you may find at least the hybrid debt funds meeting your investment objectives. Many debt funds categories may still offer an opportunity to make higher return which may work for many investors. For savvy investors the flexibility and ability to gain from market volatility will be bigger attractions to stick to debt funds.

When to go for FDs
FD loyalists have a new reason to stick to their preference. If you are a conservative investor who prefers certainty of return and do not fall in the higher income tax bracket, you may still find FDs attractive. If the total interest income from a bank FD is less than Rs 40,000 in a financial year, there will no TDS deduction. “For an Investor who has a long term held to maturity profile and regular income requirement, Bank FDs will serve the purpose,” says Singh. If you are a senior citizen, then there is no TDS on interest income up to Rs 50,000 from bank FDs and there is also a deduction of Rs 50,000 allowed under section 80TTB in a year which can very well be utilised by senior citizens.