New Tax Changes for Debt Mutual Funds: Are FDs & NCDs Better?

Changes to Debt Mutual Fund Taxation Benefit

The recent budget announcement has made a significant change to the tax benefit of debt mutual funds. Starting from 1st April 2023, debt mutual funds purchased after this date will not get the benefit of long-term capital gains tax, regardless of the holding period.

Previously, if you redeemed a debt fund after 3 years, you were taxed at 20% with the benefit of indexation, which effectively reduced the tax to 10-15%.

It is not clear why this was added last minute. But does this mean you should start investing in Fixed Deposits instead?

Advantages of Debt Mutual Funds Over Fixed Deposits

Despite this new provision, debt funds continue to enjoy some big advantages over fixed deposits.

• Firstly, there is no tax till you actually redeem the debt fund.
• Secondly, set-off and carry-forward of gains and losses is possible.
• Thirdly, no TDS is applicable on debt funds (unlike FDs which have tax deducted at source or TDS). Carrying forward or set-off of losses allows the taxpayer to reduce taxable income in the current year and year in which the losses are carried forward.
• Lastly, debt mutual funds are more flexible than FDs. In FDs, you create a fixed deposit of a certain amount. If you want to withdraw a smaller amount, you need to break the whole FD. There are some exceptions like sweep-in and sweep-out, but their accounting is complex. In the case of debt mutual funds, you can invest and withdraw any amount on any business day.

For all of these reasons, the case for debt mutual funds is STILL strong, although less strong than it was earlier. Remember that it only affects new investments after 1st April 2023, not your existing debt mutual funds.

Risks Associated with NCDs

Now let's consider NCDs or non-convertible debentures and bonds issued by corporates to raise funds for their business from individual investors among others. Some of the recent NCDs are being offered at coupon rates of 8.5% – 8.75% per year.

Given the low-interest rates offered by fixed deposits and even some types of debt mutual funds, it may be tempting to allocate funds here.

However, while returns are visible, it is important to consider the risk as well before putting in your money. NCDs come with all kinds of risks including interest rate, credit risk, and liquidity risk.

Let’s see how these debentures compare with debt funds in these three aspects.

1. When Interest Rates Change

Firstly, when interest rates change, bond prices react by moving in the opposite direction. If interest rates in the economy are moving up, prices of existing bonds tend to fall. The opposite also happens.

In a falling interest rate scenario, the prices of existing higher-yielding bonds tend to rise thanks to a higher demand to earn better yield. In the case of NCDs, if you plan to hold till maturity, this risk will not affect you because you will receive all your interest payouts and the principal at the end.

In short-term debt mutual funds like liquid funds, interest rate risk is irrelevant.

2. Creditworthiness of the Company

Secondly, credit risk refers to the possibility that the issuer of the bond may default on its payments. In the case of NCDs, the credit risk will depend on the creditworthiness of the issuing company.

Before investing in any NCD, it is essential to do thorough research on the company's financials and credit ratings to evaluate the credit risk.

On the other hand, debt mutual funds also carry credit risk. However, since these funds invest in a diversified portfolio of bonds, the risk is spread across several issuers. This diversification helps in reducing credit risk to a large extent.

3. Liquidity Risks

Lastly, liquidity risk refers to the risk of not being able to sell the bond when you need to. In the case of NCDs, these bonds are usually listed on stock exchanges, but there is no guarantee that you will be able to sell them easily.

In contrast, debt mutual funds are highly liquid. You can buy and sell units of these funds on any business day at their prevailing NAVs.

Overall, while NCDs may seem attractive due to their high coupon rates, they carry various risks that need to be taken into account before investing. Debt mutual funds, on the other hand, are still a strong investment option, albeit with reduced tax benefits from April 2023.

Conclusion

In conclusion, the recent budget announcement has brought significant changes to the tax benefit of debt mutual funds. From 1st April 2023, debt mutual funds purchased after this date will not get the benefit of long-term capital gains tax, regardless of the holding period. However, despite this change, debt mutual funds still offer several advantages over fixed deposits and NCDs, including no tax until redemption, set off and carry forward of gains and losses, no TDS, and flexibility.