What is the cost of investing in debt mutual funds - Motilal Oswal
What is the cost of investing in debt mutual funds - Motilal Oswal

What is the cost of investing in debt mutual funds

Normally, it is equity funds that we normally associate with costs. The general belief with debt funds is that they entail a lower cost compared to equity funds. That is correct in the sense that even the Total Expense Ratio (TER) on a debt fund a stipulated by SEBI is much lower. However, since yield on debt funds is at least 500 to 600 basis points lower than equity funds, the debt fund managers make it a point to keep the costs in check. Let us look at debt fund fees and taxation aspects. The debt mutual fund tax calculation has certain unique aspects to it which needs to be factored in.

 

Exit Loads do exist for debt funds

Many investors tend to believe that debt funds are free of exit loads. That is absolutely wrong. It is only liquid funds which invest in liquid assets with the lower maturity that actually are exit load. That is because, these liquid fund are designed to permit institutions and corporate treasuries to park funds for the short term. Any exit load will take away the prime attractiveness of these liquid funds. However, all other classes of debt funds do attract exit loads. Be it liquid plus funds, short term bond funds, credit funds or gilt funds, they all entail exit loads. Of course, the exit loads are lower than in case of equity funds but that still adds to your cost in case of early exit.

 

Total Expense ratio (TER) is a key cost component for debt funds

If you take a cursory glance at the fund factsheet of a debt fund, you will find clear mention of the total expense ratio. This ratio is normally lower than equity funds but still ranges between 1% and 1.5% in case of longer maturity debt funds. Of course, the TER is much lower in case of shorter end funds. The SEBI stipulation for TER is as under:

 

Average Weekly AssetsLimit for Debt SchemesFirst Rs.100 crore of equity fund AUM2.25%Next Rs.300 crore of equity fund AUM2.00%Next Rs.300 crore of equity fund AUM1.75%Balance assets above Rs.700 crore1.50%

 

So how would the maximum expense ratio be calculate if the debt fund is managing Rs.2500 crore. Here is how it will work.

 

Slab of AUM of the Debt FundExpense Debit to the Debt FundMaximum TER AllowedFirst Rs.100 croreRs.2.25 crore2.25%Rs.101 crore to Rs.400 croreRs.6.00 crore2.00%Rs.401 crore to Rs.700 croreRs.5.25 crore1.75%Rs.701 crore to Rs.2500 croreRs.27.00 crore1.50%Effective TER of the FundRs.40.50 crore1.62%

 

In the above case, for a debt fund with a corpus of Rs.2500 crore, the actual TER percentage will be subject to a maximum of 1.62%. Normally as fund size grows larger, the effective TER will come down. While the TER is an annual cost, the proportionate cost is allocated on a daily basis and debited to the end-of-day NAV so that the NAV reflects a clear picture of the net asset value of the fund.

 

How are dividends on debt funds taxed?

Like in the case of equity funds, debt fund dividends are also tax free in the hands of the investors. But debt funds have to pay a substantially higher rate of Dividend Distribution Tax as compared to equity funds. This DDT on dividends declared by debt funds will be deducted at the rate of 29.12% (25% tax + 12% surcharge + 4% cess) and only the net amount will be paid to the investor. So if the dividend declared is Rs.10 then the investor in the debt fund will only receive a net dividend of Rs.70.88 after deducting the DDT. Thus there is really no great advantage in opting for the dividend option of a debt fund because the DDT is almost same as what you pay on short term gains on debt funds.

 

Tax implications on capital gains on debt funds

In case of debt funds, the tax treatment is different from equities because the definition is different . In case of debt funds long term is defined as a minimum holding period of 3 years. Any gain arising before 3 years will be taxed at your peak rate of tax (30%) applicable. However, in case of long term gains on debt funds (held for more than 3 years), the tax rate applicable is just 20% after considering the benefit of indexation. Let us understand how indexation works towards reducing your tax burden substantially. Check the table below:

 

Debt Fund PurchaseAmountDebt Fund RedeemedAmountBuy NAV of DB FundRs.100Sell NAV after 3 yearsRs.127.10Annual CAGR Returns8.3%Redeemed onApril 02nd 2017Buy DateMarch 28th 2014Holding Period3 years & 4 daysBuy Index Value220 (IT prescribed)Sell Index Value275Indexed cost of BuyRs.125Capital GainsRs.27.10

Indexed capital gainRs.2.10

Tax on LTCGRs.0.42

Effective Tax rate
(0.42/27.10)1.55%


When it comes to cost of debt funds, you need to understand the power of dual indexation. In the above case, dual indexation has reduced the investor’s effective tax rate to just 1.55%.
 

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