Debt Funds: It Is Time to Be Fair to the Poorer Cousin

India has traditionally been a market where investors value safety. Bonds, fixed deposits, and debt mutual funds have long been the preferred choice for conservative investors and institutions. Yet, over the past few years, debt mutual funds have increasingly been treated as the poor cousin in the investment ecosystem.

From the gradual withdrawal of tax benefits to unfavourable post-tax returns, debt funds have faced a steady erosion of investor appeal. This is not just a product-level issue. It has broader implications for asset allocation, risk management, and the financial stability of household portfolios.

Why Debt Funds Were Once Core to Portfolios

For decades, debt funds played a central role in Indian portfolios.

They were widely used by:

• Conservative retail investors seeking income and stability
• Institutions managing liquidity and short-term surplus
• Investors balancing risk alongside equity exposure

Debt funds offered diversification, predictable returns, and a structured alternative to traditional deposits. They also allowed investors to access a wide range of instruments such as government securities, corporate bonds, and money market instruments through professionally managed portfolios.

How Debt Funds Lost Their Lustre

The decline in the popularity of debt funds did not happen overnight. It was the result of multiple factors unfolding over time.

Persistently Lower Returns

As interest rates declined, returns from debt funds moderated. While this was a natural outcome of the rate cycle, it reduced the relative attractiveness of debt compared to equity, especially during prolonged equity bull markets.

Tax Treatment Became Less Favourable

Over time, debt funds began to lose their tax advantage compared to equity funds. Higher short-term tax rates and longer holding periods for long-term classification made debt funds less efficient on a post-tax basis.

Credit Events and Loss of Confidence

A series of credit-related events in certain debt schemes affected investor confidence. While these were not representative of the entire debt fund universe, they left a lasting impact on perception.

Removal of LTCG and Indexation Benefits

The most significant blow came when the Central Board of Direct Taxes (CBDT) removed long-term capital gains treatment and indexation benefits for pure debt funds. Any mutual fund with more than 65% exposure to debt instruments is now taxed like a bank deposit, regardless of how long it is held.

The Asset Allocation Problem This Has Created

From a financial planning perspective, this shift has created a structural problem.

Ideally, asset allocation should be built primarily around:

• Equity for growth
• Debt for stability and income

Other asset classes should play a supporting role. However, when debt becomes unattractive in post-tax terms, investors are pushed toward higher equity exposure than their risk profile may warrant.

This distortion:

• Increases portfolio volatility
• Raises behavioural risks during market downturns
• Undermines long-term financial planning discipline

Debt funds are not meant to compete with equity on returns. Their role is to stabilise portfolios. Current tax rules make that role harder to fulfil.

How Debt Funds Are Taxed Today

The disparity becomes clearer when comparing the tax treatment of equity and debt funds.

• Equity mutual funds qualify for long-term capital gains after 12 months.
• Debt mutual funds require a holding period of 24 months for long-term classification.

However, for pure debt funds with more than 65% exposure to debt instruments, the concept of long-term and short-term capital gains no longer applies.

Even if such a debt fund is held for five years:

• Gains are treated as other income in the year of redemption
• Tax is levied at the investor’s highest marginal slab rate

The limited benefit of indexation, which earlier helped adjust gains for inflation, has also been removed.

Why This Creates an Uneven Playing Field

The current structure throws up several inconsistencies.

A listed bond becomes a long-term capital asset if held for just one year. However, the same bond held inside a mutual fund structure is taxed at slab rates if the fund qualifies as a pure debt fund.

This discourages:

• Collective investing through regulated MF structures
• Retail participation in professionally managed debt portfolios

From a policy standpoint, this creates an uneven playing field between direct bond investing and debt mutual funds, despite both serving similar economic functions.

What Changes Are Being Asked For

Restoring balance does not require complex reforms. Several rational steps have been consistently suggested by industry bodies such as AMFI.

Key proposals include:

• Restoring long-term capital gains treatment for debt funds
• Reintroducing indexation benefits to account for inflation
• Extending the ₹1.25 lakh capital gains exemption currently available to equity funds to debt funds as well
• Introducing a Debt Linked Savings Scheme (DLSS) on the lines of ELSS, allowing investors to save tax through conservative mutual fund products

These changes would encourage rational asset allocation and allow debt funds to reclaim their role in long-term portfolios.

Why This Matters Beyond Taxation

Debt funds are not just an investment product. They are a stabilising force in the financial system.

A healthy debt fund ecosystem:

• Reduces over-reliance on equity markets
• Improves household financial resilience
• Supports orderly capital allocation

Treating debt funds fairly is not about favouring one asset class over another. It is about restoring balance and encouraging disciplined investing.

Key Takeaways

• Debt funds were once core to Indian investor portfolios
• Falling returns and adverse tax changes reduced their appeal
• Removal of LTCG and indexation benefits was a major setback
• Current taxation distorts asset allocation decisions
• Debt funds face unfair treatment compared to direct bond investments
• Restoring tax parity can improve portfolio stability and investor outcomes

Disclaimer: This article is for general information and educational purposes only. It does not constitute tax, investment, or legal advice. Tax laws are subject to change, and individual circumstances may vary. Readers should consult a qualified financial or tax professional before making any investment or tax-related decisions.