No more indexation benefits for debt mutual funds; what should investors do?

Indexation benefits will no longer be available to debt mutual funds held for more than three years. Furthermore, they will be ineligible for the 20 per cent tax rate. What should investors do? Continue reading to learn more.

With regard to the exclusion of long-term capital gains and the indexation advantage, Finance Bill 2023 has proposed significant modifications to debt mutual funds. The proposal will be applied to investments made on or after April 1, 2023, provided it is passed by the Parliament.

But, according to experts, the changes would put debt mutual funds and bank fixed deposits (FDs) on an equal footing. So, in this case, should investors rush towards investing in bank FDs or continue with their investments in debt mutual funds? In this article, we would try to figure out whether you should invest in bank FDs or debt mutual funds.

Bank FDs Historical Performance

In this section, we are looking at the historical performance of bank FDs to gauge how they perform in different interest rate markets against debt mutual funds.

As can be seen in the above graph, the Bank FD returns are at their historical lows. Having said that, in FY 2023 the average bank FD rate is at 7.79 per cent. If we look at the historical median bank FD rates, then it is around 7.8 per cent.

Debt Mutual Funds Historical Performance

To understand the performance of debt mutual funds, individuals look at category performance. Hence, we have used 5-year rolling returns over the period ranging from January 2013 to March 23, 2023. Moreover, we would also be looking at their minimum, maximum and median returns.

If we look at the performance, then compared to bank FDs it seems to be weak. However, these are category returns. And individual fund returns may differ from that of category. To give you an example, the category median 5-year rolling returns of corporate bond funds is 3.8 per cent, while that of HDFC Corporate Bond Fund is 8.57 per cent. In fact, the fund’s minimum returns if 6.8 per cent and 72 per cent of the time this fund has delivered returns between 8 per cent to 12 per cent. Therefore, it would make little sense to gauge the performance of debt mutual funds based on category.

What Should Investors Do?

So, in debt mutual funds, fund and category selection matters a lot. While investing in Debt Funds, investors should understand the present interest rate cycle, credit cycle, how the yield curve looks like and what is the state of the economy. Doing so will help you to select the right category of debt funds. Then use rolling returns to gauge performance and rolling maximum drawdown to understand the risk to find top funds. Post this, looking at their portfolio is a wise thing to do. Despite the removal of the indexation benefit, debt mutual funds still look to be a prominent option. Although the post-tax risk-reward would certainly get affected. Debt mutual funds now sit between the bank FDs and equity mutual funds & stocks. So, if you can take risks and your investment horizon is long-term, then certainly you can opt for debt mutual funds.