Debt MFs retain tax benefits on RBI Retail Direct Scheme

when you buy one government bond, you are paid annual or half-yearly interest on the same. This interest is fully taxable at your slab rate and is taxed every year. Conversely, if you buy the same government bond through a debt mutual fund, interest accrues with the mutual fund. You are not taxed until you redeem your units in the fund. If you hold the fund for more than three years, you are charged a capital gains tax of 20% and the benefit of indexation.

Mutual funds have introduced several schemes called ‘Target Maturity’ funds which buy and hold bonds till a certain target maturity date. This allows investors to have an experience similar to actually buying and holding government bonds. If you want to exit before the target date, the fund also offers better maturities than the secondary market for selling small amounts of government bonds (called odd lots). On the other hand, you pay the expense ratio in mutual funds but it can be quite low.

For example, in Bharat Bond ETF, which is managed by Edelweiss Mutual Fund, the expense ratio is 0.0005%. If you buy Bharat Bond Fund of Funds, which invests in ETFs, the expense ratio is still as low as 0.05%. Bharat Bond ETFs invest in AAA rated public sector bonds instead of government bonds, but the default risk for PSUs is relatively low. The 2031 Bharat Bond ETF has a Yield to Maturity (YTM) of 6.80% (as of November 15), compared to the Government of India bond yield of 6.36%. Bharat Bond is just one example of a target maturity mutual fund. There are several other schemes in this category that confine themselves to low-risk debt such as state government bonds or public sector bonds.

“Liquidity is the most important advantage that debt mutual funds have over buying bonds directly. There is also tax benefit, MFs are facing lower effective tax rate due to capital gains tax rules. Third, there is a convenience approach. It is a small advantage but it is good to have all your investments in one place instead of locking it across multiple platforms,” said Suresh Sadagopan, Founder, Ladder 7 Financial Advisory, SEBI Registered Investment Advisor.

Apart from Bharat Bond ETFs, mutual funds have launched several targeted maturity products. For example, the Nippon Dynamic Bond Fund has an average maturity of about 8.9 years (close to benchmark 10-year government bonds) and invests in state development loans (SDLs). It has a target maturity structure.

Axis Mutual Fund has AAA Bond Plus SDL ETF of 2026 maturity, which could be useful for someone with a tenor of five years.

Sovereign gold bonds (SGBs) are an exception to the tax benefits that mutual funds enjoy. SGBs are not subject to any capital gains tax or other income taxes if held to maturity. The term of SGB is eight years. You can also sell SGBs before maturity and in this case they will be subject to 20% long-term capital gains tax after the holding period of three years. This would be similar to the tax on Gold Exchange Traded Funds (ETFs) and Gold Funds of Funds (FOFs). The interest of 2.5% on SGB is fully taxable at your slab rate.