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How You Can (Still) Play Bond

Given the changed taxation of debt funds, should you stop investing in them? No. Find out why they're still worth investing in

Debt fund managers and their investors have been in quite a tizzy after the changes in the taxation of debt mutual funds announced in the recent budget. Even the much-awaited 'clarification' has proved to be a damp squib with the Finance Minister exempting transactions between April 1 and July 10 alone, from the new provisions.

Confused by all the tax tweaks and the negative press that debt mutual funds have been receiving, many investors are in fact asking: Should I just stop investing in debt funds and go back to the predictable world of savings bank accounts and fixed deposits?

The answer actually, is No. Firstly, tax breaks should never be the primary motivation to decide on your asset allocation or investment choices. These should be based only on one parameter -returns. And secondly, most people seem to be overestimating the impact of the tax changes in the budget on debt mutual funds. While some types of debt funds such as 1-3 year FMPs have been rendered unattractive by the changes, other categories of open end debt funds remain quite attractive for their ability to generate high returns, offer anytime liquidity and the flexibility to switch your money to the best performing fund at point in time. This makes them a good fit for any investor's portfolio. So, here are three factors you should keep in mind while investing in debt funds post-budget.

Long-term scores over short term
The budget has aligned the taxation of returns on less than 3-year debt fund investments with bank deposits. But remember, debt mutual funds remain very tax-efficient for investor who can stay with them for 3 years or more. If you can stay invested for 3 years or more, your capital gains from debt funds will now be taxed at 20 per cent after accounting for inflation indexation benefits. This is still a pretty good deal for investors.

Just consider a simple example. Suppose you invest ₹100 in a debt fund today and it earns a 9 per cent annual return over the next three years and you decide to redeem it in August 2017, just after the 3-year period. Every ₹100 you invested would have grown to ₹129.5 at the end of 3 years. The sum of ₹29.5 would be the long term capital gains that you earned. Now, assuming inflation was at 8 per cent per annum in these years, you will be able to 'index' your initial investment for the effect of inflation, increasing your original costs to ₹126. Thus, only ₹3.5 in long term capital gains would be subject to tax at 20 per cent; effectively resulting in taxes of ₹0.70. The remaining return would be tax-free.

Therefore, investors who park money with debt funds for three years or more will still get several benefits - market-linked returns from an actively managed portfolio, anytime liquidity for emergencies and minimal tax implications on their capital gains.

Active funds score over passive funds
By removing the tax advantage that debt mutual funds enjoyed over bank deposits of up to 3 years, the FM has levelled the playing field between the two avenues on taxation. But he hasn't done anything to the debt fund managers' ability to deliver a superior return through active portfolio management. Therefore, while the tax changes make passive products like FMPs, unattractive, don't forget that actively managed funds can still deliver a superior return over bank deposits.

In the case of open end products such as short term debt funds, income funds, dynamic bond funds and gilt funds, fund managers have plenty of scope to generate high returns by actively juggling between bonds of different maturity and credit quality. How can a bank deposit match up to this return?

Just forget the tax breaks and take stock of how open end debt funds have fared in the last 3 years on their returns alone. Locking into bank deposits 3 years ago would have yielded you an annual interest of about 8-8.5 per cent. But in the same period, liquid funds and short term debt funds as a category have averaged a return of 9 per cent CAGR, income funds have yielded 8.6 per cent and gilt funds about 8 per cent. This was in a choppy and rising interest rate scenario. If interest rates fall, as most fund managers expect over the next 2-3 years, open end funds will have far greater scope to deliver higher returns through active management of their portfolios, as bond prices appreciate.

What is more, while most bank deposits offer much the same returns with minor interest variations of 25-50 basis points, there is a world of difference in returns between the best and worst performing debt fund, within each category. Taking stock of returns over the past three years, the best open end debt funds have clocked 10-11% returns, delivering returns that were 100-150 points above the category average. Thus, if you are able to select the best actively managed funds, you may be able to earn better returns than on bank deposits.

Growth over Income
If the budget has forced debt investors to take a more long-term view of their debt investments, it also nudges them to go for growth over dividends.

A change in the method of calculation of Dividend Distribution Tax (DDT) in the budget will now trim the effective returns to investors from the dividend options of debt mutual funds. To simplify the DDT provisions, as of now, a fund house paying ₹100 as dividend to its investors on their debt funds computed DDT at ₹28.33 (DDT of 25 per cent plus surcharge and cess) and deducted this from its surplus before paying the dividend. But the budget has made it compulsory for it to calculate the DDT on the gross amount of ₹128.33, including the DDT. Thus, a fund which earlier paid a dividend of ₹100 would now be able to pay only ₹92 as dividend to its investors.

The impact of this move may vary slightly between those who hold debt funds for less than 3 years and those who hold them for longer periods. If you hold your debt fund for less than 3 year and are in the 30 per cent tax bracket, the dividend option (with 28.3 per cent DDT) will still work out marginally superior to the Growth Option (taxed at 30.9 per cent). Investors in the 10 and 20 per cent tax brackets may now find the Growth option better as their returns would be taxed at their slab rates which are lower than the DDT of 28.3 per cent. But if you intend to hold your fund for more than 3 years, the Growth option is now better than Dividends for all categories of taxpayers. Returns from the growth option would be taxed at a minimal rate after indexation benefits, but the Dividend option returns would get taxed at 28.3 per cent.