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The principal is not protected in gilt funds

FUND QUERIES

BS Reporter  |  Mumbai 

How safe is it to invest in gilt funds? Will it be correct to assume that the principal remains protected? With interest rates falling, what are the indicative returns from this category?

-K Srinivas

Gilt funds invest only in government bonds, so they don't face the risk of default on their investments. But their value can go go down, if interest rates go up. They also appreciate when interest rates go down. Hence, your principal in gilt fund is not protected from losses. There are no indicative returns for this fund category.

Recently Religare Mutual Fund acquired Lotus Mutual Fund. All unit holders have been given an option to redeem units before Religare takes over. What is the impact of this acquisition on investors? Does it make sense to remain invested?

-Appanna

The ownership of Lotus Asset Management Company (AMC) has changed recently and it has been renamed as Religare AMC. This means new management for its funds. The two owners are not very different. Both are relatively new players without any pedigree in the asset management business. We are quite neutral to the ownership change at Lotus. Investors should decide on the basis of specific fund performance and tax implications of moving their money elsewhere. What will be the tax incidence, if I opt for dividend stripping, to reduce tax liability.

-Bhaskar P

Dividend stripping refers to use of dividends declared by a mutual fund to lower one's tax liability. If you expect a mutual fund to declare a dividend soon, you can buy its units before the record date. Evidently, the dividend is paid from the existing corpus of the fund and thus the net asset value (NAV) reduces. To show losses, the investor sells the units after the record date of dividend payment. The fall in the NAV amounts to capital loss. The dividend from equity fund does not attract any tax. The investor, hence, does not have to pay tax due to the loss. In reality, the investor has made a profit if the value of the dividend and the NAV is combined.

However, the benefit of dividend stripping no longer exists. Under the revised laws, it has been provided that if an investor acquires a unit within a period of three months from the record date and sells or transfers the same within a period of nine months from the record date, then any loss arising from the transaction shall be ignored. This is to the extent that the loss does not exceed the amount of dividend. Thus, one cannot avail of any tax benefit from dividend stripping.

I live in the US. I want to know what is the procedure to invest in mutual funds in India. Please tell me whether there are any other investment avenues and whether I will need to pay tax on the capital gains?

-Venkat

US residents are not allowed to make any investment, which is not registered with the US Securities and Exchange Commission. Hence, Indian mutual funds are not an eligible for you. The way around the rule is to provide an Indian address for such investments.

The other way to invest in Indian market is through India dedicated offshore funds, which you can buy locally. Real estate, gold, portfolio management services and direct equities are other investment options you can look at.

In respect of tax obligation arising from mutual funds, Non-Resident Indian need to pay short-term capital gain tax at 16.99 per cent for equity schemes and 33.99 per cent for debt schemes.

Long-term capital gains are tax-free for equity. For debt it is 11.33 per cent without indexation or 22.66 per cent with indexation. Although dividends are tax-free in the hands of the investors, a dividend distribution tax is paid by the AMC. The fund house deducts this from the money that will eventually go to investors. Tax deduction at source is applicable for long-term capital gains at 22.66 per cent for debt and is not applicable for equity funds.

In case of short-term capital gains, 33.99 per cent is deducted for debt and 16.99 per cent for equity.

In the bond fund matrix, you have often said that gilt funds are liable to get affected with RBI’s interest rate changes. When you say so, are you referring to a change in the Cash Reserve Ratio (CRR) or a change in the repo and reverse repo rates?
How should one select debt funds for long-term wealth creation via SIP?

-Eshan

The summary of bond fund matrix gives a snapshot of the credit risk as well as the interest rate risk borne by a bond fund.

Gilt funds are highly sensitive to interest rate risk. Any change in CRR or repo and reverse repo rate affects their prices, as demand changes. Thus, the interest rate outlook drives the demand and bond prices.

Fixed income investment is not a suited vehicle for long-term wealth creation. Equity, even though it is more volatile, is considered more suitable to build wealth. Investing in a equity fund via SIP is recommended. Fixed income investment can be one time investments for risk-averse investors. The choice of funds depends on your investment horizon. A fixed income allocation plays an important role in a long-term portfolio to provide stability and ensure discipline for rebalancing.

As you are looking for a bond fund for the long-term, we suggest well-rated income funds like Birla Sun Life Dynamic Bond Fund, Kotak Flexi Debt Fund, Fortis Flexi Debt or IDFC dynamic Bond Fund.

Value Research

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First Published: Sun, December 28 2008. 00:00 IST
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