Home / Money / Personal Finance /  Debt MFs retain tax advantage over RBI retail direct scheme
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Prime Minister Narendra Modi recently inaugurated the RBI Retail Direct Platform through which retail investors can directly buy government bonds as well as sovereign gold bonds. With the exception of sovereign gold bonds, there are no tax benefits for investment in government bonds through this platform. This leaves the strategy of directly buying government bonds at a distinct disadvantage compared to mutual funds. The liquidity in the secondary market for small quantities of such bonds also tends to be poor.

When you buy a government bond, you are paid annual or semi-annual interest on the same. This interest is fully taxable at your slab rate and it is taxed every year. In contrast, if you buy the same government bonds through debt mutual funds, the interest accrues with the mutual fund. You are not taxed till 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 given the benefit of indexation.

Mutual funds have launched a number of schemes called ‘target maturity’ funds which buy and hold bonds till a certain target maturity date. This allows ‘buy and hold’ investors to get an experience similar to actually buying and holding government bonds. If you wish to exit before the target date, the fund also offers far better maturity than the secondary market for selling government bonds in small quantities (called odd lots). On the flip side, you pay an expense ratio in mutual funds but this can be quite low.


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For example, in the Bharat Bond ETF, which is managed by Edelweiss Mutual Fund, the expense ratio is 0.0005%. If you buy the Bharat Bond Fund of Funds, which invests in the ETF, the expense ratio is still a low 0.05%. The Bharat Bond ETFs invest in AAA rated public sector bonds rather than government bonds, but the default risk for PSUs is relatively low. The 2031 Bharat Bond ETF has an yield to maturity (YTM) of 6.80% (as of 15 November) compared to the Government of India bond yield of 6.36%. Bharat Bond is just one example of target maturity mutual funds. There are a number of other schemes in this category that restrict 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 directly buying bonds. The tax advantage is also there, with MFs facing a lower effective tax rate due to capital gains tax rules. Third, there is a convenience standpoint. This is a minor benefit but it’s good to have all your investments in one place rather than having them locked up on multiple platforms," said Suresh Sadgagopan, founder, Ladder7 Financial Advisories, a Sebi registered investment adviser.

Apart from the Bharat Bond ETFs, mutual funds have launched a number of target maturity products. For instance, Nippon Dynamic Bond Fund has an average maturity of around 8.9 years (close to the benchmark 10-year government bond) and it invests in State Development Loans (SDLs). It has a target maturity structure.

Axis Mutual Fund has a AAA Bond plus SDL ETF of 2026 maturity, which can be useful to someone with a five-year time horizon.

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

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