Debt mutual funds in India which were a tax efficient option for lower risk investors in the Indian capital market took a beating when its taxation got tweaked in a recent Union Budget whereby its gains were simply taxed at the investor’s overall income tax slab rate. There was a course correction of sorts in the very next Budget where some further tweaks were made for a new predominantly debt oriented hybrid investment category with an equity taxation rate albeit with a two year holding period was proposed.
This has led to some innovative products and the Income Plus Arbitrage Fund, which strategically allocates investments into a combination of debt-oriented mutual fund schemes and arbitrage funds, is one of them. Typically, such a fund invests about 50–65 percent in debt mutual fund schemes and 35–50 percent in arbitrage opportunities, placing it in the Fund-of-Funds (FoF) category. The debt component is aimed at offering stability and visible income, while the arbitrage portion offers tax efficiency. With precise structuring, the fund can qualify for equity-like taxation, making it an attractive option for tax-sensitive investors.
The primary reason for a low to moderate risk investor to consider an Income Plus Arbitrage Fund is usually its tax efficiency. A FoF that maintains at least 35 percent exposure to equity instruments, even if it is through arbitrage positions, can help the fund qualify for equity type long-term capital gains (LTCG) taxation if held for over two years. This means capital gains, if any, will be taxed at 12.5 percent, which is significantly lower than the tax on traditional debt funds or fixed deposits, both of which are taxed as per the investor's income tax slab.
The debt portfolio can be diversified across corporate bond funds, short-term or long-term debt funds, government securities (G-Secs), and ultra-short duration funds or floaters. Meanwhile, the arbitrage component exploits price inefficiencies in equity markets through a hedged and risk-neutral strategy, often resulting in low-risk, stable returns, especially in volatile or range-bound market environments.
There are some other reasons too for debt investors to consider investing in an Income Plus Arbitrage Fund, besides the tax-optimized return. These funds exhibit lower volatility than typical hybrid equity funds due to their higher debt allocation and low-risk arbitrage exposure. They also facilitate flexible rebalancing strategies without triggering any tax implications for the investor, as all rebalancing happens at the fund level.
Another advantage is diversification—not just across asset classes, but also across multiple fund managers in fund houses, reducing the risk of poor performance due to single-point failures. Lastly, these funds are designed to offer consistency across different market cycles, dynamically adjusting their strategy based on market conditions to ensure stable and predictable returns even during turbulent periods of rate or credit changes.
These funds are better suited for long-term investors with an investment horizon of two years or more. They make good sense for conservative investors who prefer stability over volatility due to aggressive equity exposure and are simply looking for higher after-tax returns compared to traditional fixed income options.
(Ashok Kumar heads LKW India. The views expressed here are his own)