Mutual funds push for indexation relief on debt funds in FY27 Budget wishlist to FM

The mutual fund industry has urged the finance ministry to restore indexation benefits on debt mutual funds as part of a broader set of capital market proposals discussed during recent pre-Budget consultations, according to people familiar with the matter.

Industry representatives flagged concerns that the withdrawal of indexation benefits has distorted fixed-income investing, led to excessive concentration in high-rated debt instruments, and impaired price discovery in the bond market, the people said. The emphasis of the discussions was on long-term market development rather than short-term tax considerations.

The recommendations were made during consultation meetings held last month and attended by representatives from the Association of Mutual Funds in India (AMFI), the Association of Registered Investment Advisors (ARIA), broker associations, and other capital market bodies. Moneycontrol has reached out to AMFI for comment.

Impact of debt fund taxation on bond markets

The withdrawal of indexation benefits has altered behaviour of market participants that is impacting bond market pricing in rather undesirable ways.

With debt mutual fund returns now taxed at an investor’s marginal income-tax rate regardless of holding period, the post-tax advantage of taking duration or credit risk has diminished sharply. For many investors, especially those in higher tax brackets, the incremental yield offered by lower-rated or longer-duration instruments is no longer sufficient to compensate for the higher volatility and credit risk after taxes.

As a result, fund managers have increasingly gravitated toward higher-rated, shorter-duration securities where capital stability is prioritised over yield enhancement. This has led to a concentration of flows into AAA-rated bonds, treasury bills, and money market instruments, market participants said.

The shift has also weakened demand for lower-rated and longer-tenor bonds, particularly in the AA and below segments, raising borrowing costs for issuers in those categories and reducing trading activity. With fewer participants willing to price credit or duration risk, price discovery in segments outside the top-rated universe has suffered, a top industry official said.

The AUM of debt funds (excluding shorter-duration and fixed-income funds) rose to Rs 5.04 lakh crore in 2025 from Rs 4.16 lakh crore in March 2024. Quantum Mutual Fund’s Sneha Pandey explains, “Part of the reason AUM hasn’t fallen is the cyclical nature of the rate cycle. During rate-cutting phases, flows into debt schemes rise, while rate hikes lead to outflows. Investors in long-duration and dynamic bond funds typically have a fixed allocation for fixed income and prefer these instruments over FDs for slightly higher returns over a three- to four-year horizon.”

Why the indexation benefit was taken away

Even last year, during the pre-budget consultations, AMFI had sought the restoration of indexation benefits for long-term capital gains on debt mutual funds, arguing that indexation ensures investors are taxed only on real, inflation-adjusted returns. The benefit was withdrawn in Budget 2024, a move AMFI had warned would disproportionately hurt retail investors who use debt funds for income stability and capital preservation.

The withdrawal of indexation benefits was aimed at aligning the tax treatment of debt mutual funds with that of bank deposits and other fixed-income instruments, a move widely viewed by the industry as an attempt to support deposit mobilisation at a time when bank deposit growth was slowing.

Are mutual funds diverting bank deposits

Market experts, however, argue that the assumption that mutual funds divert savings away from banks is not entirely correct. Credit intermediated through debt mutual funds ultimately reaches borrowers, who typically route and temporarily ensure these funds remain within the banking system as current deposits before being spent, allowing the money to recirculate through banks.

Under current tax rules, equity-oriented mutual funds attract a short-term capital gains tax of 20 percent and a long-term capital gains tax of 12.5 percent for holdings beyond 12 months. Debt mutual funds, however, are taxed at the investor’s applicable income-tax slab rate irrespective of holding period, following the removal of indexation.

In the last budget, no mutual-fund-specific measures were announced in the last Budget, though the finance minister unveiled a revised tax framework that exempted incomes up to Rs 12 lakh under the new tax regime.

Other budget proposals for capital markets

Beyond debt fund taxation, capital market-related industry bodies also proposed a reduction in securities transaction tax (STT) on cash market trades and called for simplified know-your-customer (KYC) norms to improve financial inclusion and onboarding, the people said.

Finance Minister Nirmala Sitharaman has completed 10 rounds of pre-Budget consultations in New Delhi for the upcoming Union Budget 2026–27, covering sectors including agriculture, capital markets, and manufacturing, according to recent reports.