Modify your debt portfolio to minimize impact of new tax rules

Debt funds have lost their advantage over bank fixed deposits. The Union Budget has increased the period after which gains from them will be considered as long-term from 12 months to 36 months.

This could prove to be a body blow for debt funds, which account for 75% of the mutual fund industry's assets under management (AUM) of over Rs 10 lakh crore. Though most of the money parked in debt funds comes from companies, retail investors will also be hit as there are debt funds-such as fixed maturity plans (FMPs) and monthly income plans (MIPs)-that have been designed specifically for retail customers.

The change calls for modification of investors' debt portfolio. Before we give suggestions on how to go about it, here's a low-down on how the Budget proposal impacts your investments.

WHAT DID IT SAY?
The Budget has increased the longterm capital gains tax on non-equity mutual funds from 10% to 20% without indexation. Tax rates for long-term capital gains 'with indexation' remain the same.

Indexation is adjusting the amount invested with inflation to arrive at a new higher purchase price. This is deducted from the investment value at redemption to arrive at capital gains on which tax is to be paid. That is why indexation reduces capital gains for taxation. The benefit is only for long-term capital gains.

The Budget has also increased the period for which one has to remain invested for these gains to be considered as long-term from 12 months to 36 months.
 
HOW IT IMPACTS YOU
If you invested in a 370-day FMP in the last week of March 2014 with the aim of benefiting from double indexation (by taking the indexation benefit for two years) by redeeming the investment in April 2015, you will not be able to do so because indexation benefits now kick in only if you have remained invested for more than 36 months.

The question now is where to invest for one-three years as FMPs for that period are no longer attractive. "Investors will have to weigh the alternatives. I think FMPs, despite the new tax rules, still score over bank FDs," says Bexy Kuriakose, head of fixed income, Principal Mutual Fund.

DOES THIS CALL FOR A CHANGE IN DEBT STRATEGY?
Yes. With tax benefit on debt funds with maturity of up to three years coming to an end, your short-term investments have to be based on your risk appetite and liquidity.

"Investors will now have to assess their risk profile first before deciding whether to invest in debt funds or bank FDs," says Manish Jain, a certified financial planner.

Here's how you can change your portfolio to match your risk profile, maturity and return expectations.

If you are risk-averse: Go for bank/corporate FDs. Banks are offering 9-9.5% on three-year deposits. Some corporate deposits are offering slightly more.

One big plus of this is that the returns are guaranteed, though there are some disadvantages as well. Liquidity, for one, is an issue. FDs have a fixed tenure. Premature withdrawal is allowed but on payment of penalty. Usually, in case of premature withdrawal, the rate of interest is reduced by one percentage point.

"You plan to buy a car in, say, two years and accordingly lock your money in an FD of similar tenure. Now, if you delay the plan, FD does not give you the flexibility to change the withdrawal date. This option is there in open-ended debt funds," says Suresh Sadogopan, founder, Ladder7 Financial Advisories.

Try actively-managed funds if you are not averse to risk: The tax arbitrage may be gone but debt funds can generate higher returns than banks FDs because of exposure to a diverse set of securities, including corporate debt, government securities and other money market instruments. For investments up to one year, you can invest in liquid and ultra liquid funds. They invest mostly in money market instruments such as certificates of deposits (CDs) and commercial papers (CPs).

"If one is looking for a product with the same risk profile as FMPs, one may opt for ultra short-term funds, which invest mostly in money market instruments," says Alok Singh, chief investment officer, Bharti Axa Investment Managers.

Liquid funds invest in securities with maturity of not more than 90 days, while ultra short-term funds can invest in securities with tenure of more than 90 days.

However, liquid and ultra short-term funds are actively-managed (which means fund managers change portfolio frequently to generate better returns). Therefore, their fund management charges are higher than that for FMPs, which are passively-managed (securities are held till maturity).

For two-three years, short and medium-term income funds can be ideal given that interest rates are not likely to go up from here. Income funds mostly invest in corporate bonds and government securities, and, therefore, are more volatile than FMPs, which follow the hold-to-maturity strategy.

Roll Over FMPs which mature next year: If you had invested in an FMP in the last week of March with the aim of redeeming it sometime in April 2015, you will not be able to avail of the indexation benefit for two years now.

You can either redeem your investment next year and pay shortterm capital gains or roll it over to three years. Fund houses are allowing investors to extend the investment period from one year to three years. However, the rolling-over strategy has a catch. The risk profile of three-year FMPs will be different from that of one-year FMPs.

"Three-year FMPs will mostly invest in long-term debt papers such as corporate bonds and not in money market instruments (like one-year FMPs). This makes threeyear FMPs riskier than the oneyear schemes," says Alok Singh of Bharti Axa Mutual Fund. 

Opt for dividend option if you are in the highest (30%) tax bracket: Though this may not offer much relief, under the dividend option, you pay an overall tax of 28.325% (25% +10% surcharge +3% education cess) compared to 30.09% (including education cess) shortterm capital gains tax you will otherwise pay. Those who earn more than Rs 1 crore (tax slab 33.99%) could save up to 5.5 percentage points by opting for dividend plans.

Under the dividend option, a part of the capital appreciation is paid through dividends. As and when the dividend is paid, the net asset value, or NAV, the per unit price of the fund, comes down by the same proportion as the dividend paid.

For example, if the NAV of the fund is Rs 15, and it pays Rs 3 a unit as dividend, the NAV comes down to Rs 12. If the investor decides to redeem his units at that price, his total capital gains will be Rs 2 (assuming he bought them at Rs 10). So, he will have to pay 30.09% (33.99%) tax on Rs 2 and 28.325% on Rs 3.