How To Earn Better Post Tax Returns Using Bond Funds

This article explains how bond funds can be used to optimise post tax returns on fixed income portfolios.

For investment decisions, tax efficiency is something investors always look at. Though tax efficiency is an essential ingredient of an investment operation, it should not be the sole norm of picking an investment. Today we will however try to understand how to optimise tax incidence on your fixed income portfolio using bond funds.

Fixed income investments are routed mostly through the mutual fund route. Investors prefer mutual funds because mutual fund offers the advantages of liquidity and accessibility. You can sell mutual fund units to fund house and get your money quickly. The minimum investment in bond fund starts at Rs 5000 which makes it affordable for even the small investor. In terms of tax efficiency, provided you have a horizon of three years and invest in the growth option, debt oriented mutual funds are much more tax efficient than bank fixed deposits. Let us see how.

Interest on bank deposits is taxable at the slab rates, and at the highest tax bracket it is taxable at 30% plus 15% surcharge (if you earn more than Rs 1 crore per year) plus 3% cess = 34.54%. Otherwise, at the highest tax bracket, it is at 30% plus 3% cess = 30.9%. Investment in debt mutual funds, for a horizon less than 3 years, may be either (a) in the growth option, which is taxable as short term capital gains (STCG) at the slab rates as discussed above or (b) in the dividend option, where there is a dividend distribution tax (DDT) applicable, @ 28.84% for individuals and 34.5% for corporates.

The tax efficiency kicks in for a horizon of more than three years. It is taxable as long term capital gains (LTCG) with the benefit of indexation. As an illustration, let us say the initial investment value is Rs 100, the fund returns are 8% CAGR i.e. Rs 100 becomes Rs 125.97 over 3 years and the cost inflation indexation (CII) is 4.5% per year. By virtue of CII, the purchase cost gets indexed to Rs 114.12. Hence, the taxable component is Rs 125.97 minus Rs 114.12 = Rs 11.85. At a LTCG rate of 20% plus 15% surcharge (if you earn more than Rs 1 crore per year) plus 3% cess i.e. 23.69%, the tax is Rs 2.81 and the net return is Rs 25.97 minus Rs 2.81 = 23.16. For investors earning less than Rs 1 crore per year, tax will be little lower. If it were a bank deposit, it would be taxed at 34.54% and the net return would be Rs 17 instead of Rs 23.16.

In mutual funds, for investments in growth option of debt oriented funds, there is another avenue for tax planning. For investors who have short term or long term capital loss, short term capital gains from mutual funds can be set off, leading to tax efficiency. For example, if there is short term capital loss from equity, it can be set off.

Within the mutual fund space, let us now look at other categories of funds, with some deviation from conventional fixed income funds, but which are relevant for fixed income oriented investors. There is tax efficiency in (a) Arbitrage Funds and (b) Equity Savings Funds. Let us understand the nature of these funds.

Arbitrage Funds play with the price differential, known as arbitrage, between equity shares in the cash market and stock futures market. This is done for 65% or more of the portfolio, and the balance is invested in money market instruments. These funds are technically equity funds and enjoy the tax efficiency, which is no LTCG tax for a holding period of more than 1 year, no dividend distribution tax, only STCG tax for holding period of less than 1 year, which is 15% plus surcharge and cess. To be noted, though these are technically equity funds, there is no directional call on the equity market. That is to say, equity stock prices may move up or come down, but arbitrage funds derive their income from the stock – futures arbitrage. The break-even return, for a return of say 6.25% from arbitrage funds, at a tax rate of 28.84% (which is the DDT rate for individuals in debt funds) is 6.25% / (1-28.84%) = 8.78%. In the current situation, a return of 8.78% or higher from debt funds is ambitious.

Equity savings funds are a different breed altogether. There is exposure to equities, unhedged, to the extent of 25% to 45% of the portfolio. There is an arbitrage component as well, like arbitrage funds. Put together the long unhedged component and the hedged component make up at least 65% of the portfolio. This makes it technically an equity fund and the tax treatment is that of an equity fund. The difference between Arbitrage Funds and Equity Savings Funds is that in Arbitrage, there is no open position in equities as it is completely hedged, whereas in Equity Savings there is unhedged exposure to equities of 25% to 45% of the portfolio – which makes the later a bit risky bet. Conservative fixed income investors can look at Arbitrage Funds for an allocation in the portfolio. If you are willing to take a bit more risk with your money consider investing in equity saving fund.



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