Bonds vs. Debt Funds

Why Taxing Times are Changing the Game

 

A recent development has come as a rude jolt but as an education to investors.

 

The point has been driven home hard: the only certainty in the market is the taxation of gains.

 

Investors in Indian markets have progressively seen their gains being subjected to taxes, either through removing a tax break or introducing a tax.

 

This has miffed investors, who feel they have been short-changed by the government.

 

Nothing could be farther from the truth.

 

As a welfare state, the Indian government is committed to ensuring the welfare of all citizens and collecting taxes is one of the ways to fund it.

 

For a long time, investments have been promoted as tax savings instruments rather than to generate wealth.

 

The Indian government gave tax breaks to encourage the development of the financial markets, and it is natural for these tax breaks to be withdrawn when a critical mass is achieved.

 

What has changed?

 

All gains from debt funds and exchange-traded funds, international funds, gold funds and some categories of hybrid funds, irrespective of the holding period, will now be taxed at the tax rate applicable to you. In effect, long-term capital gains tax benefits and indexation benefits are abolished.

 

What was it earlier?

 

Gains from mutual funds, if held over three years, were subject to long-term capital gains of 20%, along with indexation benefits. This is applicable until March 31, 2023.

 

Was the tax rate different from gains from bonds and fixed deposits?

 

Yes, the tax rate for bond gains and interest income from fixed deposits differed.

 

Interest income from fixed deposits and bonds got taxed at the individual's income tax slab rate, which may result in higher tax liability for individuals in the higher income tax brackets.

 

 

When did the tax rate for debt funds change?

 

This happened after the Lok Sabha approved the Finance Bill 2023 in the fourth week of March. The bill will become an Act after the Rajya Sabha, and President approve it.

 

With the removal of tax arbitrage between debt funds (capital gains) and bonds/FDs (interest income), all three investment options will be treated equally from a taxation perspective.

 

Now, investors must consider other factors such as risk, liquidity, and investment objectives when choosing an investment option rather than solely relying on tax benefits.

 

Apart from the taxation of interest, listed bonds also attract capital gains tax.

 

Short-term capital gains will be taxed at an individual's income tax slab rate, while long-term capital gains are taxed at 10% without indexation.

 

One should remember that interest income is more critical for bondholders than capital gain.

 

Buying bonds turns attractive

 

Due to the change in the taxation of debt mutual funds, investors may consider good-quality bonds, as they may offer comparable tax benefits. Of course, liquidity in the secondary market is a factor to be considered when buying them.

 

Debt mutual funds took away the liquidity risk, making them a preferred investment option for many investors.

 

Debt funds also offered the ability to defer taxes as gains were taxed only on redemption.

However, the removal of indexation benefits for long-term capital gains tax in debt mutual funds will hit investors seeking tax-efficient compounding benefits.

 

The new tax change does not impact investors already invested in debt funds but only those who seek to make fresh investments after March 31.

Learn bond picking

 

You might have, so far, heard only of stock picking.

Welcome to bond picking.

Bond picking, too, requires the same skills and expertise that stock picking needs.

Just as equity research analysts recommend buying stocks, there are fixed-income experts and investment advisors who can help you choose bonds based on your risk profile.

 

You can also read our earlier blog posts, "Chase The Yield", "Cashflow, Heartbeat Monitor of Bonds", and "Ratings, the pedigree identifier of bonds", to understand different aspects to be considered when choosing a bond to invest.

 

 

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