As debt fund tax sops fade, are arbitrage income funds the last haven for conservative investors?

For investors wary of equity market swings but unwilling to compromise on tax efficiency, arbitrage plus income funds may be the only sweet spot left. Recent tax changes have upended the relative advantages of traditional debt funds, forcing conservative savers to rethink their portfolio allocations.

“Earlier, debt funds had a tax advantage over fixed deposits (FDs). But after that tax benefit was removed, debt fund returns became taxable as per the investor’s tax slab. Since many investors fall into the higher tax brackets, the post-tax difference between FDs and debt funds became negligible,” explained Arun Kumar, vice president and head of research, FundsIndia.

An income plus arbitrage fund is a type of mutual fund that combines investments in arbitrage funds and debt funds. The primary goal is to provide debt-like stability while benefiting from favourable tax treatment. The scheme aims to invest in units of arbitrage and debt mutual fund schemes, with less than 65% of its total assets in units of debt mutual fund schemes.

This has led to the rise of a hybrid product: the Income Plus Arbitrage Fund. These funds typically allocate between 35% and 65%, with the debt allocation not exceeding 35%. This specific allocation helps them qualify for a more favourable tax treatment than pure debt funds. This blend offers a powerful combination of return consistency and tax efficiency, without fully diving into the stock market.

“This structure offers a much cleaner and tax-efficient option for investors, hence its popularity,” Kumar added.

Sailesh Jain, fund manager, Tata Asset Management, said, “Income plus arbitrage funds, which are hybrid fund of funds (FoFs), currently deploy money predominantly into arbitrage funds and corporate bond funds to manage return consistency and liquidity risk, especially in volatile or low-interest environments. In general, in a falling interest rate scenario, equity investment gets the fillip. This, in turn, leads to price movement creating requisite volatility to generate higher returns in an arbitrage fund.”

The appeal is particularly strong for those in higher tax brackets, especially retirees or conservative savers who prefer safety over speculation but are increasingly concerned about post-tax returns eroding their yields.

“Indeed, one of the best choices available right now for conservative investors, especially those with a long-time horizon, is Income Plus Arbitrage Funds,” said Rohan Goyal, investment research analyst, MIRA Money.

To qualify for equity-like taxation, Income Plus Arbitrage Funds typically maintain at least 65% allocation in equity-oriented instruments, primarily through arbitrage strategies (which are treated as equity for tax purposes). The remaining allocation, up to 35%, goes into debt instruments. This structure enables the fund to enjoy equity taxation while offering better return consistency through debt exposure.

“Even while they may experience some short-term volatility due to arbitrage positions, their long-term risk-reward balance is quite favourable. This is particularly true for conservative investors who want tax benefits and consistency,” added Goyal.

A deeper look reveals a product that ticks several boxes—but also demands discipline.

Pros

Tax efficiency: Possibly the most alluring feature. High-income investors gain greatly from this in terms of their post-tax returns.

Return stability: These funds typically offer consistent bond-like returns due to their around 60% allocation to fixed-income instruments, with the arbitrage component acting as a buffer against volatility.

No lock-in period: Unlike certain conventional fixed-income products, this one gives investors flexibility in terms of liquidity.

Cons

Holding period sensitivity: To benefit from tax efficiency, a minimum 2-year holding period is essential. Early redemption can nullify the tax advantage.

Short-term volatility: Although the stock arbitrage component is low risk, it may cause some short-term volatility, particularly during major market dislocations.

Complex structure: Because they are hybrid, FoFs may be difficult to grasp for first-time or inexperienced investors.

“In summary, income plus arbitrage funds can deliver better after-tax returns than traditional debt funds, even for investors in higher tax brackets and those looking for a balanced risk-return profile,” said Jain.

So, who should consider these funds?

“For purely conservative investors who don’t want equity exposure, the only two categories left with a tax advantage are arbitrage funds and income-plus-arbitrage funds. All other options would require equity exposure to enjoy tax benefits,” Kumar summed up.

In essence, arbitrage income funds offer a tax-smart middle ground for the safety-first investor, provided one is willing to stay invested for at least two years and understand the basic mechanics behind arbitrage.