– By Rahul Bhutoria
The announcement on removal of indexation benefits by the finance ministry in the March of 2023 led to a record inflow of funds in debt instruments especially in Target Maturity Funds (TMF). This inflow was historical in the month of March as the removal of indexation benefit was going to get effective from April 2023. This strategic move was prompted by the anticipation of the removal’s effect from April 2023, driving investors to lock in yields at the outset of their investments to safeguard principal amounts effectively. TMFs emerged as an optimal choice, offering a multifaceted advantage: mitigating duration risk, preserving the indexation benefit for holdings exceeding three years, securing maturity yields, and capitalizing on the impending increase in the Net Asset Value (NAV) amid a stabilizing rate cycle.
This scenario underscores the growing influence of taxation on investment decisions, highlighting a paradigm shift in asset perception and strategy. Post-April 2023, the allure of debt funds dimmed, as evidenced by their diminished AUM growth and net outflows within the fiscal year, a trend that also affected Fixed Maturity Plans (FMPs) and Market Linked Debentures (MLDs) due to the revised taxation laws. The long-term ramifications of removing indexation benefits have reshaped the investment landscape, elevating products like Arbitrage funds, which have seen significant growth in 2023 with average returns of 7.6%, the highest since 2015. The appeal of Arbitrage funds stems from their favorable tax treatment as equity funds, contrasting with the higher tax rates applied to debt fund returns, which can escalate to 30% depending on the investor’s tax bracket. One of the important reasons for such flying colors of Arbitrage funds are because they are treated as equity funds and enjoy the indexation benefit, as against this Debt fund returns are taxed at the investors’ slab rate irrespective of the investment duration, which can be as high as 30 per cent.
The popularity of Arbitrage funds has increased significantly and the AUM from March 2023 to December 2023 has increased by 100%. They offer less risk than equity mutual funds and better taxation. The top three schemes (~60% of category AUM) in the Arbitrage category have a maximum 3 year drawdown of 0.15% and recovery of only 6 days . However, the rolling returns are approx. 4.5% only. Also, as more money comes to Arbitrage funds the returns start reducing. The leading schemes within the Arbitrage category experienced minimal drawdowns and swift recoveries, suggesting a risk profile akin to that of debt funds but with potentially unmet return expectations for some investors.
The other alternative option that could be explored in such a case is the Equity Savings Category. Equity savings funds essentially generate returns by investing in equity, debt, and arbitrage opportunities. Using derivatives, Equity Savings Funds try to reduce the net equity exposure of the fund typically between 15-35%. For the top three schemes in the category (~60% of category AUM), the 3 years max drawdown was about 4% with average recovery days of 30 days and also they do carry more risk than Arbitrage funds. However, the rolling returns have been ~9%, which is double that of the Arbitrage category. With AUM swelling by approximately 55% from March to December 2023, these funds offer a promising avenue for higher returns, albeit with increased risk compared to Arbitrage funds.
It is obvious that removal of indexation benefits from debt products has pushed investors away from plain vanilla debt instruments. Similarly, banks’ inclination to lend only to high-rated businesses, to maintain their low NPA levels, has further created a vacuum for lower-rated businesses to raise funds. Investors in High tax brackets have been impacted by this and have been exploring other alternative investments which offer high pretax return but come with higher risk. Here Performing credit is seen to be filling up this void. The yield between 14-18% in the performing credit space is attracting investors towards this product class. While Arbitrage and Equity Savings reduce risk and enhance return due to equity taxation or saving returns, Private Credit AIFs take higher risk to generate higher pretax return. These are more appropriate for investors who have larger portfolios and higher risk appetite since the min investment is Rs 1 crore and above as per regulations.
The taxation landscape exerts a multifaceted impact on investment dynamics, altering asset class attractiveness and investor strategies. For high-bracket taxpayers, the swift adaptation to tax changes is crucial for maximizing opportunities in an evolving market, showcasing the critical role of strategic foresight in navigating the fiscal complexities of investment. The dynamic approach and quick reaction to taxation announcements can help in making most of the available opportunities with asset classes becoming lucrative.
(Rahul Bhutoria is the director and founder at Valtrust.)
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