Go for debt funds if you want tax-efficient returns

The RBI has increased the key interest rates again last week in their quarterly review. The move is seen as a pre-emptive amid rising crude oil prices and food prices. The central bank, however, maintained the ‘neutral’ stance and thus projecting to be not hawkish yet. Though, not much has translated in terms of deposit and loan rates for the consumers, the overall situation seems to be on the ascend. 

Increasing interest rates is a good sign for the conservative investors who wish to park their funds in bank deposits but the tax treatment on the interest is a pain point. 

For conservative investors looking for tax efficient returns, they could explore debt mutual funds (MF). Debt MFs invest predominantly in instruments that are debt and/or fixed income securities like T-bills (treasury bills), Government Securities (G-Sec), coporate bonds, money market instruments and other duration-based instruments to generate capital appreciation or regular income to the investors. The debt funds have relatively lower cost structure, less volatility, reasonable safety and stable returns. 

There are various classifications in these funds based on the type of instruments they hold. The returns of these funds are dependent on their credit profile and average maturity periods.

Liquid funds for instance primarily invest in money market instruments like T-bills, certificate of deposits, commercial paper and term deposits. The objective of these funds is to generate returns without compromising the liquidity for the short periods of time. Investors could withdraw from these funds within 24 hours on any business days while some of the fund houses have even launched instant redemptions with some restrictions. 

Income or bond funds invest in varied fixed income securities such as bonds, debentures and G-Sec with different maturity profiles. Though instruments like Government bonds are virtually no default risk due to their sovereign guarantee, they are subjected to greater volatility as changes in the country outlook, currency fluctuations and some government policies could define the direction of the bond prices.

In funds where the investments are dominated by long-term government securities, the fund returns could be volatile and greater attention is required in timing the transactions for investors’ advantage. Investors in debt funds could generate regular income by opting for dividends. The dividends from debt funds are tax-free at the hands of the investors while a dividend distribution tax is paid by the fund house.

But investors have to be careful about making investments in these funds and should be aware of the holding periods of the funds. Investors have to assess their risk profile and investment timelines to match funds that suit their requirements. The long-term gilt funds are volatile and could lead to short-term losses also. 

The credit profile of the portfolio of a fund is a key determinant of the return generation. Of course, higher risk doesn’t always translate to better returns and hence the credit profile helps on to understand the type of risk associated with that fund. Also, the average maturity shows the portfolio’s average holding period which would help the investor check if the timelines match their goals.

As bonds and interest rates have inverse relation, investors should be wary of the yields during these times. It’s always better to opt for investing with 3-year horizon and in growth option to benefit from the taxation. 

Long-term capital gains (three years and above) are taxed in these funds at 20 per cent with indexation benefit while the short-term gains are taxed as per the individual income tax bracket. 

Despite their tax efficiency, investors shouldn’t hurry to move their bank deposits or post office deposits to debt funds without considering the risk
profile. (The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)