Mutual funds engineer new category in quest 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.

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.

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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.

This is why the MF industry has created the ‘debt advantage’ or ‘income plus arbitrage’ category. Given the novelty of the product, no particular name has yet crystallised but most schemes adopting this approach call themselves income plus arbitrage fund of funds (FOFs).

These schemes put 65% of the portfolio in debt and the remaining 35% in arbitrage funds – the exact reverse of what pure arbitrage funds do (35% debt and 65% arbitrage).

So far Axis AMC, ABSL AMC, DSP AMC, Bandhan AMC and Kotak AMC have created these income plus arbitrage FoFs by rejigging existing debt funds. HDFC AMC has filed documents with Sebi for a similar construct,