Why Debt Funds Are Losing Shine: Tax Woes & Low Awareness Drive Investors to Hybrids and Equities

MUTUAL-FUNDS
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AuthorRiya Kapoor|Published at:
Why Debt Funds Are Losing Shine: Tax Woes & Low Awareness Drive Investors to Hybrids and Equities
Overview

Debt mutual funds are seeing slower inflows compared to hybrid and equity funds in India, a trend persisting for over two years. Experts cite taxation changes, particularly the removal of indexation benefits on April 1, 2023, for debt funds with less than 35% equity, making post-tax returns less attractive. Lower awareness about debt funds' role in portfolio stability also contributes, as investors are drawn to equity's wealth creation stories or the safety of Fixed Deposits. The Association of Mutual Funds in India (Amfi) has requested the government to restore indexation benefits.

Debt Funds Trail Behind Hybrid and Equity Schemes in Investor Flows

Plain-vanilla debt mutual funds have experienced sluggish fresh inflows for more than two years, with 2025 continuing this pattern. Hybrid and equity mutual funds have significantly outpaced these fixed-income schemes in attracting investor capital. This trend is evident in asset growth figures, where debt mutual fund assets grew 1.3 times to ₹20 trillion from November 2023 to November 2025. In contrast, hybrid and equity fund assets saw a more robust growth of 1.8 times over the same period. As of November 2025, total assets for hybrid funds stood at ₹11.4 trillion, while equity funds reached ₹35.4 trillion, according to data from the Association of Mutual Funds in India (Amfi).

The Core Issue: Taxation and Awareness Hurdles

Experts attribute the subdued performance of debt mutual funds primarily to changes in taxation policies and a general lack of awareness about these products among investors. A significant turning point was the government's decision on April 1, 2023, to remove the indexation benefit on debt mutual funds. Previously, investments in debt funds benefited from taxation at 20% on long-term capital gains with indexation. Following the change, debt funds investing less than 35% in equity, purchased on or after April 1, 2023, now have their gains taxed at the unit holder's applicable income tax slab rate, irrespective of the holding period, and without any indexation benefits. This has significantly dampened investor enthusiasm.

Financial Implications and Investor Behavior

Sirshendu Basu, head of product management & strategy at Bandhan AMC, highlighted that with pre-tax returns from AAA-equivalent debt funds hovering around 6.75%, the post-tax returns have diminished for most investors. Consequently, investors are increasingly turning towards hybrid fund categories, seeking improved post-tax outcomes, while acknowledging the associated higher risk. Basant Bafna, head of fixed income at Mirae Asset Investment Managers (India), noted that while money invested before the tax change continues to enjoy indexation benefits through grandfathering, new investments in debt funds are now being allocated based solely on category merits. Furthermore, Sneha Pandey, fund manager, debt at Quantum Mutual Fund, pointed out that equity investing has historically benefited from extensive promotion around wealth creation, Systematic Investment Plans (SIPs), and compounding. Debt funds, conversely, are often misunderstood regarding their crucial roles in portfolio stability, income generation, and risk management. This leads many retail investors to either focus solely on equity for growth or opt for the perceived safety of Fixed Deposits (FDs), leaving limited space for debt mutual funds.

Regulatory Push and Market Reaction

The decline in investor interest is reflected in asset share data. The share of retail investors and high-net-worth individuals (HNIs) in debt fund assets has decreased from 24% in September 2024 to 21% in September 2025. In contrast, their share in equity mutual funds remained strong at 91% and saw only a slight dip in hybrid funds from 83% to 82% during the same period. Ahead of the Union Budget 2025, Amfi has formally appealed to the government to reinstate the indexation benefits for long-term debt investments, aiming to re-establish a level playing field and encourage inflows into the debt fund category.

Future Outlook

Fund managers anticipate that debt mutual funds will likely experience steady, rather than rapid, growth in the coming times. Killol Pandya, head of fixed income at JM Financial AMC, believes debt funds still have a significant journey ahead to capture the majority of small ticket investors. However, Bafna noted that current market conditions, including increased cash flow into the system by the Reserve Bank of India (RBI) and elevated spreads due to higher bank credit-deposit ratios, are making debt funds more attractive. Low-duration funds currently offer yields approximately 0.30% to 0.40% higher than one-year FDs, while short-duration funds provide 0.50% to 0.75% more, with these returns expected to stabilize after March, potentially signaling a favorable time for investment.

Impact

This news impacts investor choices in India, influencing how they allocate capital across different asset classes like debt, equity, and hybrid funds. It highlights shifts in investment preferences driven by taxation and market dynamics, relevant for Indian retail and institutional investors, as well as asset management companies.

  • Impact Rating: 7/10

Difficult Terms Explained

  • Plain-vanilla debt mutual funds: These are traditional mutual funds that invest primarily in fixed-income securities like bonds and government securities, offering predictable returns.
  • Hybrid mutual funds: These funds invest in a mix of asset classes, typically equities and debt, aiming to balance risk and return.
  • Equity mutual funds: These funds invest predominantly in stocks of companies.
  • Assets Under Management (AUM): The total market value of all assets managed by a mutual fund company or financial institution.
  • Indexation benefit: A tax provision that adjusts the cost of an asset for inflation, effectively reducing the taxable capital gain when an asset is sold.
  • Long-term capital gains (LTCG): Profits made from selling an asset held for a specified long-term period, taxed at a potentially lower rate.
  • Short-term capital gains (STCG): Profits made from selling an asset held for a shorter period, typically taxed at a higher rate.
  • Income tax slab rate: The progressive tax rate applied to different portions of an individual's income.
  • Grandfathering: A provision that allows existing arrangements or investments to continue under old rules, even after new rules are introduced.
  • High-Net-Worth Individuals (HNIs): Individuals with a substantial amount of investable assets, typically defined as over $1 million.
  • Fixed Deposits (FDs): A type of investment offered by banks that provides a fixed rate of interest over a specified period.
  • Credit-deposit ratio: A banking metric that indicates the ratio of a bank's total loans disbursed to its total deposits received.
  • AAA-equivalent debt funds: Debt funds that invest in securities rated AAA, the highest credit rating, indicating very low risk of default.
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