A Low-Risk Investment Option You Cannot Ignore

By Suresh Sadagopan

A lot has changed for the debt of Mutual Funds (MF) when the Finance Minister (FM) eliminated long-term capital gains. In effect, irrespective of when the debt MF investment is liquidated, short-term capital gains apply, which is at one’s marginal tax rates.

This has thrown a spanner in the works for Debt MFs as tax efficiency was one of the highlights while investing here. There are still many other benefits in a Debt MF as compared to an FD/ Bond/ NCD etc.

Debt MFs offer diversification due to multiple underlying papers, professional management that takes care of the credit risk and any other risks, excellent liquidity, open-ended nature and hence can be redeemed at any time, etc.  In spite of these benefits, debt MFs have lost their lustre with investors and advisors.

Why have debt products in a portfolio -  Debt products are low-risk products, some of which also offer regular income provision. Others, like Debt MF schemes, do not offer regular returns and can keep growing till they are redeemed.

Debt products give stability to the portfolio through capital protection, steady returns and offers asset diversification. For those who do not like volatility, debt products would be a good fit.

Hence, debt products can act as the bedrock in every portfolio that lowers the overall risks and brings stability, even if it offers relatively low returns. Other assets like equity, gold, real estate, etc., would also be brought into a portfolio as necessary, to spice up the returns, taking a bit more risk and accepting more volatility than in a debt product.

Debt products that are tax efficient – The returns on most of the debt products are subjected to Income tax. Hence, the effective returns after taxes are low and do not even beat inflation. This is one of the main drawbacks of the debt asset class.

While the tax efficiency of pure debt MFs have been removed, there is another category that the industry has discovered that is coming to the rescue. This category has the low risk features of a debt product, but comes with better tax efficiency if held for 2 years.

The new category is a hybrid category that is a combination of Debt & Arbitrage. In this category, the debt portion is kept under 65 per cent and the arbitrage portion is kept above 35 per cent so that it falls under a product classification, where if the Indian Equity holding is above 35 per cent, it qualifies for Long-term capital gains tax of 12.5 per cent.

Income plus Arbitrage product – MF houses have started launching products in this category in the form of a Fund of Fund. In this product, they will have debt scheme to the tune of less than 65  per cent and Arbitrage scheme holdings of over 35  per cent, which makes it eligible for favourable taxation.

While this is a hybrid category, it is a low-risk category as both debt and arbitrage are low-risk categories to start with. Arbitrage funds have been offering 7 per cent + returns over the last three years and over 6 per cent if you consider longer time frames. Debt products have the potential to offer above 8 per cent returns now and even more in a falling interest regime. Hence, the returns from this hybrid product may be between 6-6.5 pre cent post-tax, which is better than a pure debt product like an FD, Bond, NCD, etc. As mentioned earlier, this return is coming to the investor without any extra risk.

The only risk in this product is the variable nature of returns of the Arbitrage Fund. While that may be there, this product is expected to offer better tax adjusted returns compared to a typical debt product, where the interest income is applied to Income tax.

Where does this fit – As mentioned earlier, this product is a good proxy for debt investments. This can be used to offer strategic allocation in a portfolio along with other debt instruments. Also, considering that this hybrid scheme carries low risk and will not be very volatile, it also lends itself to any goal coming up after a two-year period.

This kind of product even lends itself to setting up an income stream by way of systematic withdrawals and at the same time would work out to be tax efficient even if one were to withdraw a good portion for meeting goals, contingencies or emergency requirements.

Overall, we now have got a good hybrid fund that mimics a debt product but has far better tax efficiency and consequently better post-tax returns. We can expect investors and advisors to latch on to this fund in times to come, due to the multiple positive factors that it possesses.

The author is the MD & Principal Officer at Ladder7 Wealth Planners and the author of the book “If God Was Your Financial Planner”.

(Disclaimer: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.)