Don't make this portfolio error

Jun 05, 2023

Will you continue to invest in debt funds after the change in taxation?

Someone recently asked me this question. While it surprised me, it was also revealing. It pointed to the precarious mindset of an investor. One where the focus is on a single aspect of the investment process and turns out to be the sole driver of where money must be allocated. Big mistake!

The same happens with performance too, where the decision to buy or sell is based on the latest numbers, not the fund strategy or the market cycle or the fund manager’s investment style.

Before I reveal my answer, let's break it down.

What has changed? 

The Income Tax department categorizes all sources of income under 5 heads:

  1. Salary
  2. House Property
  3. Profits and Gains from business/profession
  4. Capital Gains
  5. Other Sources

Capital Gain: When you make a profit by selling an asset, it is known as a capital gain (difference between the purchase price and the sale price).

Asset: Gold, jewellery, fixed-income instruments, stocks, mutual funds, land, buildings, houses, apartments, paintings, sculptures, and cars are examples of assets.

This is further divided into short-term capital gains (STCG) and long-term capital gains (LTCG), depending on the period of holding. For example, if you sell shares or equity mutual funds within 12 months of buying, it is STCG. If you sell after 12 months, it is considered as LTCG.

What is the tax rate for debt funds and non-equity investments?

For debt investments made from April 1, 2023 (FY23-24 onwards), the indexation benefit is gone. Investments in debt mutual funds held for three or more years used to be taxed at the LTCG rate of 20% with indexation, or 10% without indexation. Indexation is no longer available. And now the returns on debt funds are added to the individual’s income and taxed as per the individual’s tax slab.

What has not changed?

The bedrock of financial planning stays constant. So, the first step is deciding your asset allocation.

If you want your money to work towards creating wealth, ensure that your investment decisions are NEVER conducted in isolation, based only on one single input. Every single decision must be made keeping in mind the overall financial plan.

Every investment must complement the other, not compete with it. To draw an analogy, the 64 black-and-white squares on a chessboard complement each other and give structure to the layout. Each occupies a different position and serves a purpose. A chess board must have both.

It is futile to stash away money in select financial products just to save tax. Your task is to ensure that it serves your investment goals. Tax saving is not an end in itself; wealth creation is the end goal. Hence, asset allocation is important.

When you approach your portfolio with a holistic mindset, you are in a win-win situation. Because you can make sensible decisions only if you take an integrated view of your investments and goals. If you focus only on, say, tax saving, to the detriment of returns and product suitability, the price you end up paying could be really high. Unfortunately, you may realise it only much later, when it is probably too late.

Equity and fixed-income asset classes are inherently different in terms of their risk-return profile. Equities have the potential to deliver superior inflation-adjusted returns compared to fixed-income over the long term. They are the most favoured asset class for wealth generation, and should form a part of an investor’s portfolio subject to his/her risk appetite. But debt investments offer tremendous stability to the portfolio.

During certain phases, one asset class may appear dispensable. Don’t fall for that narrative. In a rampant bull market, you may question why you are invested in debt. In a brutal bear market as we witnessed in the first half of 2020, you may want to flee equity altogether. Don’t act on your impulses.

This is important:

  • No investment must ever be made taking only one single factor into consideration, be it performance or tax. They should be inputs into a process, not a divining rod.
  • You may decide not to invest in debt funds because of the taxation issue. But what happens if tomorrow the taxation on equity funds changes in an unfavourable way? Will you then consider debt funds? Will you avoid equity funds altogether? (Remember, LTCG on equity was nil at one time).
  • The bedrock of a portfolio is suitable asset allocation. The asset classes must complement the other, not compete with them. Depending on a host of factors, you will have to arrive at your own equity and debt allocation. You then work within that framework, looking at tax, liquidity, transparency, risk, time period of holding.


So am I continuing to invest in debt funds because of the change in taxation?

Oh yes! I have not changed my asset allocation at all because there has been no change in my financial situation or risk capability.

However, all my fresh debt investments will be done in a new folio for the sake of simplicity and clarity. So I know which investments (pre April 1, 2023) have the old taxation rules, and which (post April 1, 2023) have the new taxation rules.

Larissa Fernand is an Investment Specialist and Senior Editor at Morningstar India. You can follow her on Twitter

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Naveenkumar Baskaran
Jun 7 2023 12:26 AM
Very interesting article for debt funds. Loved it completely.
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