Is rising inflation favourable for your debt fund returns?

Rising inflation can be a daunting prospect, causing many to fear for their financial stability. But fear not, dear reader, for we are here to tell you that rising inflation is not necessarily bad for your debt fund returns. In fact, it can even be beneficial in some cases!

First things first, let's define our main terms. Inflation, in layman's terms, is when the cost of living goes up and your money’s purchasing power declines with time. And while inflation can lead the RBI, the central bank of India, to increase interest rates, causing a decrease in bond prices, which could impact debt fund returns, it's not always a lose-lose situation.

Debt funds are those mutual funds that invest your money in 'fixed-interest' bonds that are backed by our government and corporations. These funds can provide investors with a steady stream of income in the form of interest payments and capital gains from the appreciation of the bonds they hold. However, these funds are also subject to taxes on the income they generate.

As a wise investor, you may be wondering if there is a method to protect your savings against the ravages of inflation and rising taxes. Well, how about using one to lessen the other? One way for investors to reduce their tax liability on returns from debt funds is through indexation.

Indexation is a method used by debt fund investors to lower their tax liability on returns by adjusting purchase price of the debt fund for inflation. The indexed cost of an asset is calculated by multiplying the original cost of the asset by the cost inflation index (CII) for the year of sale, divided by the CII for the year of acquisition, i.e -Purchase price of the asset x (CII of the year of sale/CII of the year of purchase). The CII is issued annually by the Indian government.

For example, assume an investor purchases a debt fund for Rs. 1,000 in FY19. The CII for FY19 is 280 . After 3 years, the investor sells the debt fund for Rs. 1,500 in the year FY22. The CII for FY22 is 317 . Without indexation, the investor’s taxable capital gain is Rs.500 (1,500-1,000). By using indexation, we can adjust the purchase price to reflect current inflation. Now, the indexed cost of the bond would be Rs. 1,132 (1,000 x 317/280). The investor would now only be taxed on the difference between the selling price and the indexed cost which comes to a gain of Rs. 368 (1,500 - 1,132) instead of the previous capital gain of Rs.500 calculated using the unindexed cost.

But remember, to benefit from indexation, investors in debt funds must hold their investments for at least 36 months, as the indexed cost is only applicable for long-term capital gains. If an investor holds a debt fund for less than 36 months, they will be subject to short-term capital gains tax. It is important to note that, the CII changes every year and the investor should use the correct CII for the year of purchase and sale to ensure the right calculations of the indexation.

This document represents the views of Axis Asset Management Co. Ltd. and must not be taken as the basis for an investment decision. Neither Axis Mutual Fund, Axis Mutual Fund Trustee Limited nor Axis Asset Management Company Limited, its Directors or associates shall be liable for any damages including lost revenue or lost profits that may arise from the use of the information contained herein. No representation or warranty is made as to the accuracy, completeness or fairness of the information and opinions contained herein. The material is prepared for general communication and should not be treated as research report. The data used in this material is obtained by Axis AMC from the sources which it considers reliable.

While utmost care has been exercised while preparing this document, Axis AMC does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Investors are requested to consult their financial, tax and other advisors before taking any investment decision(s). The AMC reserves the right to make modifications and alterations to this statement as may be required from time to time.

Statutory Disclaimer: Axis Mutual Fund has been established as a Trust under the Indian Trusts Act, 1882, sponsored by Axis Bank Ltd. (liability restricted to Rs. 1 Lakh). Trustee: Axis Mutual Fund Trustee Ltd. Investment Manager: Axis Asset Management Co. Ltd. (the AMC) Risk Factors: Axis Bank Limited is not liable or responsible for any loss or shortfall resulting from the operation of the scheme.

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https://incometaxindia.gov.in/charts%20%20tables/cost-inflation-index.htm
https://incometaxindia.gov.in/charts%20%20tables/cost-inflation-index.htm