Arbitrage fund or short term bond funds: Which one works for you?
The tax treatment and the expected returns should you help you to decide on the right bet.
If the buoyant stock market has made you go for re-balancing your asset allocation, you are definitely looking for some investment options in bonds. And in case you are wary of interest rate risks, you would be left with two choices - arbitrage funds and short-term bond funds. “If you are in the 30 percent tax bracket, arbitrage funds should be chosen. Others can go for short term bond funds. Do not go by past returns, moderate your expected return on investments,” says Abhishek Gupta, Founder and Managing Director of Moat Wealth Advisors.
For the uninitiated the short-term bond funds invest in bonds maturing in one to two years. Arbitrage funds aim at capturing arbitrage opportunities in stock markets. The fund managers buy a share in the cash market and sell the same in the futures market simultaneously. The price differential defines the returns. Though the scheme deals in stocks and futures, the fund is not exposed to the vagaries of market. This enables investors earn almost risk-free returns.
“Arbitrage funds enjoy the treatment of equity funds for the purpose of taxation,” points out Prateek Pant, co-founder & head of products & solutions at Sanctum Wealth Management. If you invest in growth option of the arbitrage fund, then the gains are tax free if the holding period is more than one year. Otherwise, the gains are taxed as short term capital gains at the rate of 15.45%. Dividends declared by arbitrage funds are tax exempt.
Short term bond funds on the other hand are subject to tax. For investments held more than three years, all gains are taxed at 20% post indexation as long term capital gains. Short term capital gains are added to income of the investor and taxed accordingly. Dividends declared by these funds are subject to dividend distribution tax of 28.84%.
“As arbitrage funds enjoy lenient tax treatment, the post-tax returns offered by these schemes are attractive for investors in high income slabs,” says Joydeep Sen, an independent financial advisor based in Mumbai. Over last one year short term bond funds as a category, earned 8.37% whereas arbitrage funds delivered 6.24% returns. As the returns on arbitrage funds are tax-free, for an investor in 30% slab it works out to pre-tax rate of 8.9%.
The numbers may make you jump and pick arbitrage fund if you are in 30% tax slab. But here is a word of caution. “The returns offered by arbitrage funds are subject to the liquidity situation in the market,” points out Prateek Pant.
Abhishek Gupta explains, “As more money chases the price differential in the cash-future arbitrage, the price differential erodes leaving less for the arbitrageurs.”
Moderate your returns expectations going forward. Over last one year, the interest rates have come down. This has benefited the short term bond funds as the prices of bonds held in the portfolio have gone up offering some capital appreciation. Going forward there is not much room for further rate cuts. This will erode the capital gain component of the returns offered by the short term bond funds. “Do not expect more returns than the accrual income of these schemes,” says Abhishek Gupta.
For individuals in high income tax bracket, Prateek Pant advocates putting 75% of money in arbitrage funds and rest in short-term bond funds. Pant recommends investing in:Short Term Bond Funds:
Axis Short Term Fund
Birla Sun Life Short Term Opportunities Fund
DSPBR Short Term Fund
IDFC SSIF - STArbitrage Funds:
IDFC Arbitrage Funds
Kotak Equity Arbitrage Fund
ICICI Prudential quity Arbitrage Fund
Reliance Arbitrage Advantage FundFor the investors in lower income tax slabs, short-term bond funds make more sense.