IME Capital Investment Queries provide answers to common investor queries that are directly written by IME Capital’s Central Investment Team. This helps ensure centralised, common and transparent communication of our thoughts to all investors (& potential investors) of IME Capital, and helps mitigate against the disparate communication common in the wealth management industry. Please note, that the answers to these queries can be time/market-condition sensitive, or only applicable to specific types of investors.
Written by IME Capital’s Investor Desk on September 3, 2024 | Category: Fixed Income
With the change in taxation of debt funds (gains to be taxed at an investor’s income tax-slabs), we normally recommend investors invest in Arbitrage funds instead (due to their superior taxation leading to better post-tax returns). This is discussed in greater detail in our blog: Arbitrage Funds: Why Post-tax Yields are Superior to Debt Funds?
However, in a falling interest-rate environment, debt funds have the ability to generate MTM gains on their holdings, which can boost returns (possibly up to an extent where their higher returns compensate for the higher-taxation).
To answer this question, we take a simple case study that compares how post-tax returns across different categories for arbitrage & debt funds would compare in an example where interest rates were to decline by 1% each year for 2 years. We compare the 3-year post-tax returns that an investor would generate, assuming that they buy and stay invested for a 3-year period. The results are given in the able below
The result of this simplified example, indicates that in a falling interest rate envirionment, if an investor invests in a long-duration debt funds the MTM gains can actually be higher to mitigate the adverse taxation of debt funds. However, longer-duration debt funds come with a higher level of risk and also require very good timing of entry & exit, in order for these higher returns to be generated. Accordingly, with the exception of more sophisticated investors, we continue to believe that Arbitrage funds are superior to debt funds, even in a falling interest rate environment.