Decoding Debt Mutual Funds (Part II - Where they stand in the fixed income landscape?)

Now that we learnt about the basics of debt mutual funds in Part 1 of ‘Decoding Debt Mutual Funds’, let us understand the various benefits and risks involved in investing in debt mutual funds, compared to other fixed income avenues and equity. Tax implications also form a key lever in the decision-making process, and we will study that in depth as well. Finally, the study of debt mutual funds remains incomplete without studying its history.

Benefits of Debt Mutual Funds

1. Tax Deferral: Debt funds are taxed only when you withdraw money vs. annual tax on interest on FDs. This allows the unpaid tax portion to also keep compounding. Further, SWPs can be structured to replicate the periodic interest payout in FDs, deferring a large portion of tax to final withdrawal (from annual taxation)

2. Granular Liquidity: Partial withdrawal is possible in case of a debt mutual fund, subject to any exit load. FDs, on the other hand, need to be prematurely withdrawn as a whole and may entail penalty.

3. Diversification across Bonds: A single fund invests in 50-100 different bonds. This minimizes concentration risk compared to directly investing in a corporate bond/deposit.

4. Portfolio Diversification: Debt funds provide stability to the overall portfolio, partly offsetting the high volatility of equity investments. As Benjamin Graham mentions in his book ‘The Intelligent Investor’ – “We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks”.

5. Dual Return Potential: Typical fixed income instruments like bonds and FDs only give interest income. However, debt funds have dual return potential - if market interest rates fall, bond prices rise – resulting in capital gains as well in addition to interest income. A good fund manager in a dynamic bond fund can add further alpha to this if he is able to predict the interest rate cycles well.

Risks in Debt Mutual Funds

1. Interest Rate Risk: The risk that bond prices will fall as interest rates rise. (Highest in Gilt and Long Duration funds).

2. Credit (Default) Risk: The risk that the borrower stops paying interest or principal. (Highest in Credit Risk funds).

3. Liquidity Risk: The risk that the fund manager cannot sell the underlying bonds quickly enough to meet redemption pressures.

4. Reinvestment Risk: The risk that interest payments received will be reinvested at lower rates (common in a falling rate regime). However, this risk exists with other fixed income instruments as well.

The overall effect of the above risks is that though debt fund returns are stable (compared to equity), they are not ‘fixed’ like an FD or a corporate bond.

Tax Implications

The taxation of debt funds changed drastically on April 1, 2023.

• The Old Rule (until April 1, 2023): If held > 3 years, gains were taxed at 20% with indexation. This was a massive advantage over FDs as it adjusted costs for inflation.

• The New Rule (After April 1, 2023):

  • Indexation benefits were removed.

  • For investments purchased before 1 April 2023, if they are held for more than 24 months, capital gains are classified as ‘Long-term’ and taxed at 12.5%. If held for less than 24 months, they will be taxed at the investor’s slab rate

  • For investments purchased after 1 April 2023, the capital gains would be taxed at the investor’s slab rate.

• This makes the tax treatment on debt funds somewhat equivalent to FDs, though debt funds still offer the benefit of deferring tax until withdrawal (unlike FDs where interest is taxed annually).

You can go through our 3-part series titled ‘You’ve Checked the Returns, But Have You Checked the Taxes?’. We also recommend you consult with your tax advisor to better understand the tax implications during redemption and re-balancing.

Lessons from History (The "scars" and "reforms")

These events shaped the current regulatory landscape:

• Negative Events:

  • IL&FS Crisis (2018): A AAA-rated entity defaulted, triggering panic. Many "Liquid" and "Short Duration" funds that held IL&FS paper saw their NAVs drop overnight. Lesson: Ratings can lag reality.

  • Franklin Templeton Winding Up (2020): The fund house shut down 6 schemes because the bond market froze during COVID-19. They had invested in lower-rated, illiquid bonds and could not sell them to pay exiting investors. Lesson: Liquidity is king.

  • Yes Bank AT1 bonds written down to zero (2020); Ballarpur Industries’ rating change impacting Taurus MF (2017); Essel groups delay in repayment to debt MFs holding fixed maturity plans (2019). Lesson: Selection and constant scrutiny of borrowers is necessary.

• Regulatory Responses:

  • Side-Pocketing: SEBI allowed funds to segregate "bad assets" so new investors don't buy into bad debt and existing investors can eventually recover money if the bad debt pays up.

  • Risk-o-Meter: Introduction of the "Potential Risk Class (PRC) Matrix" to clearly show maximum interest rate risk and credit risk a fund can take.

Now that we have learnt a bit more about debt mutual funds, we look at how this translates into decision making for mutual fund distributors and investors in Part 3 of our Series.