Target Maturity Funds: Debt funds & target maturity funds vs FDs: Who is the winner? Feroze Azeez explains

Azeez also says that debt funds and target maturity funds will win hands down because capital gain as a head of income is one of the most attractive heads of income. Because FDs give interest income, debt funds despite short term capital gain, is a very attractive head and several set offs are possible as per Section 73.

The recently proposed amendments to the finance bill mean that from April 2023 onwards, capital gains arising from debt oriented mutual fund schemes will be treated as short term capital gains irrespective of the period of holding. Now investment in hybrid funds has emerged as a suitable option. Can you explain the different types of hybrid funds?
It is very in, to look at hybrid funds today especially after the amendment to the finance bill which got passed as well because hybrid funds mix both equity and debt. If you look at the hybrid funds, there are conservative, aggressive, dynamic asset allocation, arbitrage and multi asset allocation funds. There are five types of hybrids, if you have to classify them.

The aggressive ones, of course, as the name suggests, have a larger portion in equity. The conservative ones have a larger portion in debt. Dynamics, as the name suggests, are quite fluid in terms of their allocation and they do not stay static between their equity and debt and so on and so forth. Arbitrage funds are very debt-like in terms of behaviour, but in taxation they are like equity.

We have so many categories within hybrid funds. Equity savings is a neglected category and you can elaborate more on that because this category among hybrid schemes has the lowest AUM of almost Rs 16,445 crore, but that could change soon. For retail investors, are we looking at BAFs or equity savings that can come handy for them?
Yes, you are absolutely right in terms of the assets equity savings as a category is very small. But after the change of Section 50 AA which is the new section which was introduced on the budget day but got amended before the bill got passed and debt funds were roped in other than MLDs actually tells you that if there is anything more than 35% in equity, then the taxation of long term capital gains will be applicable and you will also get indexation.

So investors will look for schemes which have just about one third of the money in equity and the equity savings category generally has 30 to 40% invested in equity. I think this will start getting traction and there is going to be a lot of investor interest because most investors have equity of 35% and debt of 65%.

Which investor does not have 35% in equity? Most retail investors and even HNIs at least have 35%. So a combination of both of these will give tax efficiency to the debt side and will definitely find some degree of tailwind. I think this category will definitely see a push.I would like to take you back in time, maybe to early 2000 when fixed deposits were compared with income funds or there was always a debate going on between these two categories. Do you think it is similar these days?
I think you are right. Of course, the tax efficiency of pure debt funds, especially the target maturity funds, which I personally think have been the reason why this change of taxation got triggered because as per Section 48 of income tax, bonds and debentures should not get indexation.

But a target maturity fund with nothing but one or two bonds put inside a box, were getting indexation and this was a loophole kind of scenario. That is why target maturity funds going forward become less attractive. So coming back to your question, will there be a debate? The answer is yes because FD’s tax efficiency has suddenly become not so much of a problem because target maturity funds will also come as short term capital gain.

But hand on heart, I still think debt funds and target maturity funds will win hands down because capital gain as a head of income is one of the most attractive heads of income. Because FDs give interest income and debt funds despite short term capital gain, is a very attractive head and several set offs are possible as per Section 73.

What about arbitrage funds? Talking about pure debt allocation, do you think a move on the arbitrage fund will be seen? How do they work?
Arbitrage funds buy equity and also hedge the equity by shorting in the futures market. So from a return profile, it is more debt-like. From a taxation profile, because the underlying asset is equity, one is buying equity in the cash market and selling the same commodity in the futures market. So risks get canceled. The difference in the price in the two markets gives the arbitrage opportunity and that is what arbitrage funds capitalise on.

For example, if Nifty today is at 17,400, May Nifty will be at 17,500. So buying Nifty of today and selling the Nifty of 25th May which is the last Thursday of May, the Rs 100 differential is called the arbitrage opportunity. So to answer your pointed question, arbitrage funds are going to be very much in favour because they give equity taxation, not just debt taxation of the old regime and are even more favourable.

The short-term capital gains tax is only 15% and long term capital gains after one year is just 10%. I think an arbitrage fund is going to have a large flight of capital from the other debt categories which from April 1, have become less efficient from the taxation standpoint.

Do you agree with this that earlier so much of thrust was not given to a hybrid category in the debt investor category. Why was it neglected?
Mathematically, if you forget taxation, it is always good for an investor to do asset allocation at the portfolio level and not at product level. If a person has say Rs 10 lakh, he is going to decide how much will go into equity, how much will go into debt and then allocate to debt and equity separately. This has one advantage that you are in the driver’s seat when it comes to asset allocation.

Second, your debt is going to be cost efficient because if you are investing in debt, you should not spend so much money on fund managers because one cannot do too much in debt. In equity, one can spend good quality money to get the best fund management. So two advantages of doing asset allocation. That is why hybrid funds were not in favour. Now that there is a tax advantage, it makes hybrid funds more attractive than pure debt funds.

People have to relook at the advantages and measure the pros and cons and make their calls. If somebody got just Rs 2,000 to invest in a month, then a hybrid fund was always a great option. But if somebody has collected a reasonable lump sum amount, keeping equity and debt separate is always a better strategy than mixing them up.

How can debt funds be stressed by AMCs? AMCs have gone on overdrive on debt funds. Do you think the stress will be on outperformance over FDs and product features now?
Basically every financial institution is fighting for the same pie which is the household saving. According to the CRISIL Report, household savings are at Rs 3 lakh crore in India. So of course debt funds are going to have more pressure to deliver better performance than fixed deposits on a post-tax basis but debt funds will also bring in some degree of tax efficiency; even the conventional debt funds will have some degree of arbitrage to my mind or some degree of equity.

The asset management company will also push equity savings schemes. I think there will be a lot of innovative caps and as we speak. AMCs are thinking of how to bring back debt funds into post-tax efficiency so that they can compete with the FDs and have their market share as well.

Currently looking at the longer tenure bonds, do you think these are favourable for investors to invest in right now?
Longer term bonds yes. We are in an interest rate cycle which has peaked out a long time back. I have been saying this for the last seven-eight months. The 10-year GSEC has not moved up at all. Repo might have moved up from May 24th last year by 2.5% but 10-year GSEC is exactly where it was on May 24 last year. I think we are at the peak of the rate cycle.

So, if you are going to lock in yourself a 7.3-7.4% even on a Government of India bond for the next 10 years, it is very lucrative. If you go to state development loans, you are getting 7.6-7.7% but long-term corporate bonds are not of worth today because the remuneration these corporate bonds are giving is very little. If I am going to get 8% with a triple AAA rated corporate bond and 7.4% with the Government of India, I will always choose 7.4% because in 10 years, corporates can go through whatever they have to go through. Why will I take that risk for just 0.6% more? So to answer your question, government bonds, state development loans locked in for long periods of time are great ideas. Corporate spreads are so thin that it is not attractive or even worth your time for that half a percent more.