Will debt MF investors now turn to FDs with indexation sparkle gone? Here’s what market experts say

Debt mutual funds in India are taxed based on the period of holding.

The indexation benefit was a prime attraction for debt mutual fund (MF) investors. With the surprise amendment in Finance Bill 2023 that removes this benefit, there is chatter about which one is preferable for investors—a debt MF or a fixed deposit (FD).

As per the amendment, returns from mutual funds with less than 35 percent invested in equities will attract short-term capital gains with effect from April 1, 2023. With this, indexation benefit on debt MFs will be taken away. At present, investments in debt MFS over three years are treated as long-term capital gains and taxed at 20 percent with indexation benefits.

Indexation, the eye candy for debt MF investors

Indexation factors in inflation, which helps to lower taxes significantly.

Jayesh Faria, associate director and regional head (west), Motilal Oswal Private Wealth, explained that due to the indexation benefit, a large portion of gains get reduced from the taxable amount, making the post-tax return on debt funds more attractive than other modes of investments like bank FDs.

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Amit Tripathi, chief investment officer (CIO), fixed income, Nippon India Mutual Fund, had a similar view, saying, “The indexation benefit provided an incentive to long-term investors in debt MFs as compared to traditional fixed income avenues such as bank and corporate fixed deposits, G-Secs and corporate bonds”.

What happens with the indexation benefit gone?

Faria pointed out that the recent amendment brings debt MFs in line with other fixed instrument investments and will benefit bank FDs in a big way.

“Bank fixed deposit offer fixed assured return and investor does not have to worry about credit as well as interest rate risk. Wherein debt mutual fund has both these risks and hence offer higher return than traditional bank fixed deposits,” he explained.

“People in general prefer assured return without any volatility hence they prefer bank deposits. Besides, we have not seen any bank in India default so there is feeling of capital protection among investors with bank deposits,” he added.

But even as both debt MFs and FDs are now on a level playing field, some still believe debt MFs may be better.

“Debt mutual funds may still provide additional benefits like easy liquidity as most of the debt MF schemes do not have an exit load,” said Marzban Irani, CIO, fixed income, LIC Mutual Fund. Exit load is the fee that asset management companies charge investors at the time they exit their schemes.

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Despite the tax benefit ending on April 1, mutual funds will still offer several advantages over traditional fixed income avenues, Tripathi believes. He is of the view that a diversified portfolio, with very high regulatory oversight, the highest disclosure standards, large variety of solutions across the liquidity, duration and credit spectrum, active and passive solutions give debt MFs the edge.

Could this amendment impact flows to debt MFs?

Analysts at Jefferies believe that with the new amendment, flows to debt MFs could be affected. “Inflows to mid-longer duration debt MFs could moderate as removal of taxation-related benefit of pure debt mutual funds reduces its attractiveness vs. fixed deposits,” they wrote in a note.

Debt MF assets under management (AUM) was around Rs 13 lakh crore as of December 2022, of which debt MF schemes with Rs 6 lakh crore of AUM would be affected. While retail and high net-worth individual flows to debt MFs (which form 43 percent of debt MF AUM) may see some shift to FDs, corporates and institutions may still prefer investing in debt MFs over FDs due to better liquidity and return expectations when the rate cycle turns, the financial services company said.

The investment bank believes it is a negative for non-banking financial companies (NBFCs) and housing finance companies (HFCs) but should be manageable. Bonds form 36 percent of NBFC borrowings. Debt MF exposure to NBFC bonds has fallen materially following the crisis at IL&FS. Jefferies estimates that currently, debt MFs fund around 15 percent of NBFC/HFCs bonds.