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By now most of us have read the whole nine yards on Debt funds and the new taxation which is likely to hit the category.
Our idea in this note is not to belabour the ‘what and why’ of new taxation but to lay out options for the next few days.
First things first – All new investments done in any fund which has ‘domestic equity’ less than 35% will not enjoy indexation benefit and will now be taxed at a marginal rate (respective tax rate of investors) irrespective of the holding period.
It impacts all funds where domestic Equity is less than 35% which effectively covers:
- All Debt mutual funds
- All Fund of Funds
- All international funds
- All commodity funds like Gold, Silver, etc
This applies to all investments done after the 31st of March, 2023. This means all existing investments and new investments done till 31st March 2023 will continue to enjoy the benefits of indexation and lower long-term taxation at 20%.
So what should Debt investors do?
- If you are an existing investor in Medium-term or long-term debt funds – you should continue to hold your investments for as long as possible.
- If you are an existing investor in ultra-short, money market, or short-term debt categories, then:
- If you need liquidity anytime soon – continue to hold. Yields are fantastic in these categories!
- If you don’t need liquidity for another 3+ yrs – then switch these funds to long-duration funds or Target Maturity funds of the long tenor.
- If you wish to allocate fresh funds in debt – Invest in long-duration debt funds or Target Maturity funds of the long tenor.
Why are we saying Long Duration Debt funds?
- We will all concur that we are nearing the peak of the Interest rate cycle and there are minimal rate hikes ahead (perhaps 25/50 bps more).
- Foreseeable rate hikes are limited and those are broadly factored in the current market yields
- If the rate cycle starts softening from next year – investors would see good capital appreciation in their debt portfolios over and above the running yields of funds
- To capture this capital appreciation (as and when it happens) one has to be invested in long-duration funds.
- The longer the duration of the fund, the higher will be the capital appreciation fund could witness
When we say Long duration, does one need to stay invested for 10-15 years?
No, long duration doesn’t mean that one has to stay invested for that long tenor. You could be invested in a mutual fund scheme that runs a duration strategy of 10-12 years but you are free to enter/exit that fund anytime. Infact, our call is to play this duration strategy for the next 3-4 years and then decide on the fund. If one wishes to exit, you can do so anytime. And if one wishes to hold on, it’s an open-ended fund and can be held for a long.
What’s the effective benefit you can look at?
Let’s understand this with an example. Look at the below two funds:
| Funds | Expense ratio (Direct Plans) | Fund Size (in crs) | YTM (%) | Avg Maturity (Yrs) | Mod duration |
| Nippon India Nivesh Lakshaya Fund | 0.25 | 2949 | 7.55 | 21.64 | 10.2 |
| HDFC Long Duration Debt Fund | 0.25 | 115 | 7.46 | 27.56 | 11.14 |
| Nippon Nivesh | HDFC Long Duration | ||
| Current YTM | 7.55 | 7.46 | |
| Direct Plan Exp | 0.25 | 0.25 | |
| Net Yield | 7.3 | 7.21 | |
| Net Yield for 3 years (CAGR) | 1 | 23.54 | 23.23 |
| Modified Duration (in yrs) | 10.2 | 11.14 | |
| Capital appreciation | |||
| Scenario 1 – if int rates fall by 1% | 2 | 10.2 | 11.14 |
| Scenario 2 – if int rates fall by 2% | 3 | 20.4 | 22.28 |
| Total Returns in 3 years = Yield + Cap Appreciation | |||
| Scenario 1 | (1+2) 4 | 33.74 | 34.37 |
| Scenario 2 | (1+3) 5 | 43.94 | 45.51 |
| Indexation for 3 yrs | (4 indexations) | ||
| Assuming inflation @ 6% | 6 | 26.25 | 26.25 |
| Capital Gains post indexation | |||
| Scenario 1 | (4-6) 7 | 7.49 | 8.12 |
| Scenario 2 | (5-6) 8 | 17.69 | 19.26 |
| Tax @ 20% | |||
| Scenario 1 | 9 | 1.50 | 1.62 |
| Scenario 2 | 10 | 3.54 | 3.85 |
| Post-tax effective absolute returns (%) | |||
| Scenario 1 | (4-9) 11 | 32.24 | 32.74 |
| Scenario 2 | (5-10) 12 | 40.40 | 41.66 |
| Post-tax CAGR for 3 years | |||
| Scenario 1 | 9.76% | 9.90% | |
| Scenario 2 | 11.98% | 12.31% |
In summary, our current expectation from long-duration funds carrying above 10-year modified duration is this range of 9.5-12.5% CAGR returns over the next 3-4 years.
Are there risks to this calculation?
Yes, there are always risks in any investment.
- The interest rate cycle may not reduce as anticipated and that might erode some amount of capital appreciation
- The interest rate cycle may take a longer time to soften and the holding tenor can increase
- Calculations shown above are rough and very broad – actual scenarios can vary depending on lots of other factors
- All other debt risks like liquidity, market risks, credit risks, etc will always apply.
What are our key recommendations:
- Either one could go for Target maturity funds. The longer the average maturity you select higher will be the capital appreciation in a rate reduction cycle.
- Or one could go for constant maturity long-term funds. They don’t have a fixed maturity date but will constantly run very high duration in the portfolio.
| Target Maturity Funds | Year of Maturity | Fund Size | YTM | Avg Maturity (Yrs) |
| ABSL CRISIL IBX 50:50 GILT PLUS SDL APR 2028 Index Fund | 2028 | 224 | 7.59 | 4.65 |
| Bandhan CRISIL IBX Gilt April 2028 Index Fund | 2028 | 3,554 | 7.54 | 4.58 |
| ABSL CRISIL IBX GILT – APR 2029 Index Fund | 2029 | 278 | 7.57 | 6.08 |
| ICICI Prudential Nifty G-Sec Dec 2030 Index Fund | 2030 | 177 | 7.47 | 7.09 |
| Edelweiss Bharat Bond ETF Apr 2030 – Direct Plan | 2030 | 5,242 | 7.68 | 6.68 |
| Edelweiss Bharat Bond FOF Apr 2031 -Direct Plan | 2031 | 3,579 | 7.71 | 7.84 |
| HDFC Nifty G-Sec July 2031 Index Fund | 2031 | 155 | 7.49 | 8.27 |
| Edelweiss Bharat Bond FOF Apr 2032 -Direct Plan | 2032 | 2,836 | 7.72 | 9.01 |
| Kotak Nifty SDL Apr 2032 Top 12 Equal Weight Index Fund | 2032 | 1,155 | 7.79 | 8.2 |
| DSP Crisil SDLGsec 2033 Index | 2033 | 142 | 7.63 | 9.45 |
| Edelweiss Bharat Bond FOF April 2033 – Direct Plan | 2033 | 3,640 | 7.67 | 9.71 |
| Nippon India Nifty GSec Jun 2036 Maturity Index Fund | 2036 | 84 | 7.61 | 12.91 |
| Edelweiss CRISIL IBX 50:50 Gilt Plus SDL April 2037 Index Fund – Direct Plan | 2037 | 343 | 7.7 | 13.18 |
| Constant maturity long term Funds | Fund Size | YTM | Avg Maturity (Yrs) | Modified duration |
| Nippon India Nivesh Lakshaya Fund | 2949 | 7.55 | 21.64 | 10.2 |
| HDFC Long Duration Debt Fund | 115 | 7.46 | 27.56 | 11.14 |
| ICICI Pru long-term bond fund | 598 | 7.73 | 10.94 | 6.97 |
Our final take:
- Investors who wish to allocate in Debt funds, International funds, or Gold funds – should do so immediately before 31st of March, 2023.
- Within Debt funds – one should look at going for the long-duration funds to play the capital appreciation game as and when it plays through.
- Rush is to do this allocation before the 31st of March – else debt funds done post that will become fully taxable at marginal rate.
For any specific portfolio action, please reach out to your respective portfolio manager @Moneyfront or write to us at support@moneyfront.in
