For years, long-term debt funds enjoyed a cosy place in the portfolios of conservative Indian investors. Thanks to tax arbitrage benefits, especially for those in higher tax brackets, they were an attractive alternative to traditional fixed deposits (FDs).
Until April 1, 2023, debt funds had a clear tax advantage: long-term capital gains (LTCG) held for over three years qualified for indexation benefits and were taxed at 20%. On the other hand, interest from FDs were taxed at the applicable tax slab, which was as high as 30%.
But long-term debt funds have become like an endangered species in investment portfolios in recent few years. With the rising interest rate scenario, the interest rates offered by fixed deposits peaked to close to 8%, which has made debt funds look irrelevant.
Tax arbitrage goes, so did investor interest
From 1st Apr 2023, capital gains both short and long term from debt funds regardless of holding period are taxed as per the investor’s income slab. That move effectively killed the tax arbitrage that made FDs more attractive than debt funds.
As FD rates peaked close to 8% in the rising rate cycle, investors embraced FDs, leaving debt mutual funds in the cold. The predictable returns, safety, and simplicity of FDs made them a no-brainer for those chasing stability over complexity, especially when the YTM (Yield to Maturity) of debt funds trailed behind due to the rising interest rate scenario.
Hybrid funds: The stopgap solution
In response to debt funds shedding the favourable taxation, many investors began using hybrid funds to gain tax-advantaged debt exposure. Equity-oriented hybrid funds (with 65%+ equity allocation) enjoy the favourable equity taxation regime: Short-Term Capital Gains (STCG)-20% (if held < 1 year) Long-Term Capital Gains (LTCG): 12.5% beyond ₹1.25 lakhs (if held > 1 year)
Conservative hybrid funds (with 35%–65% equity) also became a popular route, with long term capital gains tax at 12.5% after 2 years and short term gains taxed at the applicable income tax slab.
But that’s not all: hybrid funds blur the lines of asset allocation
However, while these hybrids offered tax perks, they also compromised on risk insulation. With open equity exposure, they couldn’t provide the capital preservation expected from pure debt instruments. Volatility creeped in, especially during equity market swings—defeating the very purpose of having a debt allocation.
Most investors assume that the “debt portion” of a hybrid fund is stable/fixed. It’s not. Fund managers often take opportunistic calls—ramping up or reducing debt exposure based on market views. What might be a 35% debt allocation at the time of investment could shrink to 20% when valuations are expensive or ramped up during periods of market optimism/attractive valuation, without any direct communication to investors.
This undermines the purpose of taking a particular weightage aligned to the ideal asset allocation that suits the risk profile. When markets fall, investors relying on such hybrid funds can face sharper drawdowns than expected, turning what was supposed to be a low-risk core allocation into a source of volatility.
In a bear market, debt holdings cushioned within a hybrid fund would shake the psychological confidence. If the debt exposure is only through hybrid funds, when markets are at a low, all the schemes in the portfolio can be in the red due to the equity holdings. But if the debt exposure was through pure debt funds, those schemes would remain resilient with positive returns, giving some psychological respite.
Arbitrage + debt funds: A low-risk middle path
To strike a better balance, AMCs have launched hybrid funds with no active equity bets and investors have started investing in these funds. There are 2 sub-categories under this with no open equity positions.
i) Equity Arbitrage + Debt
ii ) Equity Arbitrage + Commodity Arbitrage(gold & silver) + Debt
These combinations offer stability with very limited downside, targeting 7.1%–7.2% pre-tax returns, or 6.2%–6.3% post-tax for those in higher tax slabs, as the long term capital gains tax is 12.5% instead of 30%.
But even this approach has limitations in capitalising on the full upside potential of debt holdings. As interest rates are expected to fall in the near term, long-term debt funds’ YTM is set to rise above 9%, creating a strong case for pure debt funds to outperform arbitrage plus debt funds, especially for investors who are below the 30% tax bracket.
Union Budget 2025: A quiet win for debt fund investors
The latest Union Budget brought in a lesser-known but powerful tax break. Under the new regime, capital gains of up to ₹12 lakhs in a financial year from debt mutual funds (investments made on 1st April 2023 or later) can be completely tax-free, if the investor has no other income, thanks to the Section 87A rebate.
Whereas in the case of equity-oriented funds, capital gains become taxable if total income exceeds ₹4 lakhs. For retirees, homemakers, and low-income investors, this offers a significant advantage and warrants a fresh look at debt funds.
Why is it time to recalibrate your debt strategy?
Several factors now suggest it’s time to rethink debt allocations. Falling interest rates will benefit bond prices, leading to higher returns in long-duration debt funds. YTM of quality debt funds is on an upward trend, particularly in dynamic and corporate bond categories.
Hybrid funds dilute risk protection by mixing in equities, regardless of tax benefits. Section 87A creates a zero-tax window for debt fund capital gains in the case of low-income groups.
For conservative investors and those not in the highest tax bracket, debt funds could deliver post-tax returns that beat hybrid substitutes with lower risk, volatility, and greater predictability.
Conclusion: Strategy over structure
In a post-tax-arbitrage world, the message is clear: debt funds are evolving, not vanishing. With the interest rate cycle shifting, budget benefits kicking in, and the hidden risks of hybrid strategies coming to light, investors need to reassess their debt allocations not just from a returns perspective but through the lens of risk management, portfolio stability, and tax efficiency. As the markets recalibrate, so should your strategy.
V.Krishna Dassan, Director, Dhanavruksha Financial Services Pvt. Ltd.
