Ever since finance minister Nirmala Sitharaman redefined debt mutual funds in the July 2024 budget as those that invest more than 65% in debt, there’s been an upheaval in the mutual fund industry.
That’s because pure debt funds are taxed at the holder’s income tax slab rate – which can be as high as 39% – regardless of the holding period. However, a fund that marries debt with another asset gets the benefit of just 12.5% long-term capital gains tax. The condition is that debt must be less than 65% of the portfolio. The most apt asset to pair debt with is arbitrage, so mutual funds have engineered a new product that delivers this combination.
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Conventional arbitrage funds themselves are a tax construct. They satisfy the tax requirement of 65% gross equity exposure to fit into the equity tax category but use derivatives to hedge away the risk of equity. They park the remaining 35% in debt. However, arbitrage yields move around a lot and many debt investors are not truly comfortable with this category.
A new category emerges
This is why the MF industry has created the ‘debt advantage’ or ‘income plus arbitrage’ category. Given the novelty of the product, no particular name has yet crystallised but most schemes adopting this approach call themselves income plus arbitrage fund of funds (FOFs).
These schemes put 65% of the portfolio in debt and the remaining 35% in arbitrage funds – the exact reverse of what pure arbitrage funds do (35% debt and 65% arbitrage).
So far Axis AMC, ABSL AMC, DSP AMC, Bandhan AMC and Kotak AMC have created these income plus arbitrage FoFs by rejigging existing debt funds. HDFC AMC has filed documents with Sebi for a similar construct, calling it a ‘Debt Advantage FoF’.
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Sirshendu Basu, head of products at Bandhan AMC said, “The Bandhan Income Plus Arbitrage Fund of Funds is way to balance stability and provide relatively tax-efficient returns. It invests in funds seeking arbitrage opportunities and in quality fixed-income securities, aiming to provide low-risk, consistent returns with the possibility of relatively high post-tax returns. The allocation to Bandhan Arbitrage fund is expected to provide relatively steady returns even during periods of interest-rate volatility.”
He added, “The debt allocation is invested in the Bandhan Corporate Bond Fund, which aims to lower reinvestment risk and has the potential to generate relatively consistent returns when the arbitrage spread in the equity market is low.”
Devang Shah, head of fixed income at Axis AMC, said, “We invest in debt funds of other AMCs, too, not just in our own funds. We are unconstrained on the debt side – on duration and credit – but we will stick to high-quality credit unless there’s some very big opportunity. The idea is to deliver good returns with tax efficiency. This type of fund beats most debt categories post-tax 95% of the time and hybrid categories like arbitrage 70% of the time,” he said.
Financial advisors approve
Financial advisors have given the thumbs up to the category because of the tax advantage. Vishal Dhawan, founder of Plan Ahead Wealth Advisors, said, “I don’t think it is necessary for the new category to establish a track record. I would analyse these funds based on the track record of the underlying schemes and the mix of the underlying schemes to decide whether to recommend them. The tax advantage is a big plus. On the negative side, the expense ratio on some of these funds looks high (for instance 70 basis points on the direct plan is too much). So I’d look for cheaper options within this category.”
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If you have the risk appetite, you could consider these funds as a replacement for pure debt funds on account of the tax advantage. This category may be up your alley if you invest in arbitrage funds and want a smoother ride.