Listen to this article
In March the Finance Bill 2023 was passed in the Parliament and with that the tax rule for debt mutual funds (that invest less than 35% of their assets or portfolio allocation in direct Indian equities) changed. The indexation benefit was done away with, plus it made the capital gains taxable at the marginal rate of taxation, i.e., as per one’s tax slab.
By changing the tax rule, the government placed debt mutual funds at par with bank FDs. Not only debt funds but the changes in tax rule were made applicable even to gold ETFs, fund of funds and international funds, which essentially are classified as non-equity mutual fund schemes from a taxation point of view.
But does that mean one should stop investing in debt funds and other non-equity schemes? Well, in my view, the answer is no.
Debt funds offer diversification and can address liquidity needs
Ideally, MFDs and RIAs should recommend debt mutual funds and non-equity schemes considering their risk profile, investment horizon, and liquidity needs of investors. For the short term (up to 3 years), certain sub-categories of debt funds are still worthwhile.
For instance, for investors looking to keep money aside for contingency purposes (typically 12 months of regular monthly expenses), parking money in a liquid fund for up to a year is a good option. The investments are made in safe and liquid instruments to earn slightly higher returns than interest on a savings bank account.
Similarly, to play the interest rate cycle and play duration, your clients with a long time horizon could consider some of the best dynamic bond funds. The fund manager has the mandate to build a portfolio with a dynamic maturity profile (as per the interest rate cycle) and take defined credit exposure. Currently, given that we have peaked out on the interest rate cycle, the fund managers would mainly focus on investing in short-term securities that mature early and then reinvest the proceeds at a higher rate when the interest rate cycle has peaked. And conversely, when the interest rates in the economy are expected to fall, locks in investment in longer maturity debt papers to earn a higher yield and provide capital growth.
Returns of debt funds have an edge over bank FDs
Debt funds fare well over FD in terms of returns. Liquid funds in the last 1 year have generated 5.8% absolute returns, shows the Value Research data of April 16, 2023, higher than the interest rate on a savings account offered by large banks.
Dynamic Bond Funds over the last 3 years have clocked a 6.3% CAGR also quite competitive to a bank FD. Bank & PSU Debt Funds have also generated an appealing 6.3% CAGR over the last 3 years.
Moreover, if we consider the tax impact on the interest earned on bank FDs in the respective financial year, it is subject to tax deduction at source. On the other hand, in the case of debt funds, the tax liability on the capital gains is deferred until units are actually sold.
Furthermore, if there is capital loss at the time of selling debt fund units, it helps reduce the total tax liability. Note, the Short Term Capital Loss can be set off against Short and Long Term Capital Gains while if it is a Long Term Capital Loss it can be set off only against Long Term Capital Gains.
Flexible liquidity
Another vital point is the liquidity of debt funds. When investing in bank FD, selecting the plan (interest payout or reinvestment/cumulative) and the tenure as per your liquidity needs become crucial; otherwise with the penalty levied (on the entire deposit) at the time of premature withdrawal, one could lose his money. On the other hand, in debt funds, there is an option to withdraw from the investment anytime, fully or partially subject to the exit load. Thus, with respect to liquidity aspect, there is much better flexibility.
Even investment in gold ETF is an effective portfolio diversifier
While the change in tax rule may seem discouraging to invest in gold ETFs, they are still a cost-effective, convenient, transparent and liquid way to own gold in your portfolio than holding it physically. Gold ETFs are backed by the gold of 0.995 finesse and can be safely held in a demat form. It is also better aligned to the price of physical gold.
In the present times, when inflation is expected to remain elevated, there is a possibility of economic slowdown or recession. Moreover, geopolitical tensions are simmering and stock market volatility could intensify. Under such circumstances, gold is expected to exhibit its lustre and prove its trait of being a safe haven and effective portfolio diversifier. In fact, recognising the looming uncertainty, several central banks too are adding gold to their reserves.
As per the latest data published by the World Gold Council (WGC), India added 3 tonnes(t) of gold in February 2023 and is holding a sizeable 790t of gold reserves. Thus, investors should also be encouraged to approach gold strategically by allocating around 15%-20% of the entire investment portfolio towards gold and hold with a long-term view.
Don’t be discouraged by just the change in tax rules. Be thoughtful in your approach ––whether you are an RIA or MFD.
Jimmy Patel is the CEO of Quantum Mutual Fund. The views expressed in this article are those of the author and do not reflect the views of Cafemutual.