Debt mutual funds 2.0: Life after removal of long-term indexation benefit

Mutual funds may now introduce more asset-allocation products, thereby expanding the range available to investors in the medium- to-long term.

Debt mutual funds are slowly coming to terms with an amendment in the Finance Act, 2023, which removed the long-term tax benefit of indexation – the segment’s long-standing selling point.

The government’s move, aimed at bringing parity among debt asset classes, comes at a time when retail investors were warming up to this avenue. As things stand, more than 50 percent of household financial savings are still parked in bank fixed deposits.

Until last fiscal, investments in debt mutual funds were subject to taxation at 10 percent, without indexation and 20 percent with indexation, thereby reducing the overall tax liability.

Indexation was applied on the basis of Cost Inflation Index, which factors in inflation based on the Consumer Price Index. That changes now.

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With the indexation benefit gone from April 1, 2023, all gains from investments in funds with less than 35 percent exposure to equity are to be treated as short-term capital gains and taxed as per the investor’s income tax slab. All investments made till March 31, 2023, have been grandfathered into the previous tax regime.

Impact hard to miss

Ahead of the change, March-end saw frenetic activity as individual investors — who typically invest in medium- and long-maturity debt funds — rushed to park money in these categories, in a bid to benefit from the grandfathering option as well as elevated yields in these segments at that time.

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The corporate bond fund category was the biggest beneficiary of this investment spree, garnering Rs 15,626 crore of flows in March — the highest single-month net flow for the category since the Association of Mutual Funds in India (AMFI) started declaring flow data as per the new classification announced by the Securities and Exchange Board of India (SEBI) from April 2019.

Other categories that benefited from these record inflows were long-duration funds, dynamic bond funds, gilt funds, and gilt funds with 10-year constant duration. The banking and PSU debt funds category also witnessed its second-highest monthly net flow on record of ~Rs 6,500 crore.

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At the other end, institutional investors, which usually park a large portion of their monies in money market mutual fund categories, continued with quarter-end outflows in March to meet advance tax and liquidity requirements, and reinvested most of it back in April as part of short-term parking arrangements.

^Includes corporates, banks, financial institutions (FIs) and foreign institutional investors (FIIs)

Come April, however, the long-maturity debt mutual funds, which saw an interest spike in March, had lost favour. Investor interest in the category has declined sharply, though not dried out yet.

Meanwhile, target maturity funds (TMFs), which have gained interest in the last few years, continued to gain traction. While flow data for the category is not available, the assets of TMFs increased nearly 7 percent to Rs 1.83 lakh crore at the end of April 2023 from Rs 1.72 lakh crore at the end of March.

Why debt funds still make sense

As per AMFI data for March 2023, HNIs lead individual investments in debt mutual funds, with a share of 28 percent, while retail investors account for just about 3 percent. This is not surprising, given that the arbitrage provided by the previous tax regime would have been more beneficial to HNIs, compared to retail investors who could fall in the lower personal income tax brackets.

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All the same, debt mutual funds remain attractive for reasons beyond taxation.

For one, these give investors the opportunity to invest across the debt market spectrum, depending on one’s risk-return profile.

Two, liquidity of debt mutual funds, without any cost beyond the scheme’s threshold holding period, is a big plus, especially compared with other long-term debt instruments.

Three, debt mutual funds also provide investors an opportunity to derive benefit from interest rate movements, thus enabling them to take strategic calls on their investment journey.


Four, while tax arbitrage has been removed, debt mutual funds allow tax deferment, which means they are only taxed when the investments are sold, unlike in traditional fixed deposits, in which tax is levied annually on the interest earned.

Way forward for debt funds and its investors

Adding to the virtues, the newly enforced tax parity is expected to make product development and fund management (i.e., returns) the focal point, determining investment flow among the available options.

Also, mutual funds may now introduce more asset-allocation products, thereby expanding the range available to investors in the medium- to-long term.

That said, as part of prudent financial planning, it is imperative that investors map their goals and risk-return profiles with the products before investing. Due diligence on the underlying fund, such as asset allocation, rating profile, investment strategy, and fund manager profile, are a must in the investment journey.

Jiju Vidyadharan is Senior Director – Funds and Fixed Income Research, CRISIL Market Intelligence and Analytics