Why debt mutual funds are still relevant and investment-worthy

Mutual funds

A lot has been written about gains on debt mutual fund (MF) units bought on or after April 1, 2023, becoming taxable at the slab rate, irrespective of the holding period.  Though debt funds lose their concessional tax rate of 20 percent and indexation benefit for gains on investments sold after holding three years, there is still a strong case for investing in debt funds.

Let us understand a few important nuances which indicate that these funds are still relevant and can be considered for investments.

Liquidity

Among the various benefits debt funds bring to the table, liquidity is the most important. Indian debt markets are not liquid. Bid and ask prices of securities have wide spreads. Lot sizes in the secondary market are high. Many securities are listed on stock exchanges, but many times investors find it difficult to transact near the fair value of a security, due to paucity of volumes. This challenge can be best handled by investing in debt MFs, which assure the payout of sale proceeds of units on T+3 working days.
To put it simply, an investor is paid redemption proceeds at net asset value (NAV) immediately.

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Diversification

To reduce issuer-specific risks, it makes sense to diversify. Most retail investors can identify a few good-quality bond issuers and invest in them. However, in most such cases, the portfolio is grossly concentrated, given the quantum of money an average individual investor commits.

Debt funds, on the other hand, offer a diversified portfolio across issuers, which can be accessed with even a small sum of Rs 500.

Attractive yields

Bond markets are more efficient and they discount the future faster than traditional fixed-income investments. Debt funds help investors to participate in bond markets and benefit from attractive yields. For example, in 2021-2022, the bond markets started discounting interest rate hikes of the future, and debt fund investors got to invest in those high yields, whereas traditional fixed-income avenues took time to offer higher interest rates. There are prolonged periods where bond yields are more attractive than what traditional fixed instruments are offering.

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Reinvestment risk

When an investor buys bonds, he receives interest, which gets taxed at the slab rate. Sometimes the money in the bank account gets spent and sometimes, he has to look for the best opportunities to redeploy interest receipts. Debt funds, on the other hand, do not pay tax on interest receipts, as mutual funds are pass- through vehicles exempt from tax under Section 10(23D) of the Income-Tax Act, 1961. Also, debt funds diligently reinvest the interest receipts in line with the investment objective of the scheme. This, over a period, results in better compounding.

Simplicity and convenience

Fixed-income investments are generally simple. Debt funds add a layer of convenience to fixed-income investing. Debt funds offer avenues such as Systematic Investment Plans (SIPs) and Systematic Withdrawal Plans (SWPs) for ease of investing and withdrawal, respectively.

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Debt funds are regulated by the Securities and Exchange Board of India (Sebi) and are transparent vehicles that help investors tap various investment opportunities. In the long term, this ensures that investments made by investors in debt funds tend to compound and help them to build a large corpus to achieve their goals.

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In sum, while the taxation benefit was a significant factor for many investors, there are several other benefits of investing in debt MFs that should not be overlooked.

Disclaimer: Niranjan Avasthi is SVP and Head-Product, Marketing and Digital of Edelweiss Asset Management Limited (EAML), and the views expressed above are his own.