MFs Engineer Category for Tax-Efficient Debt Funds

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.

- Neil Borate

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.

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.