Many investors look to enhance returns on their fixed income portfolio. Some investors prefer to invest in high yield bonds, and some prefer to look for more tax-efficient or low tax-rate investments in the fixed income space. High yield bonds are catching up with many investors, especially after April 1, 2023 when debt fund taxation was leveled at par with other fixed income instruments, stripping off their indexation benefit. Since the capital gains on units of debt funds bought after April 1, 2023 will be taxed at slab rate irrespective of time period of holding, the ‘tax-efficiency’ of debt funds have gone away. Investors looking for alternatives may find listed high yield bonds attractive. However, investors are generally advised to buy them with a view to hold till maturity, as they may not get to trade these near their fair value on the stock exchanges if liquidated prematurely, especially in times of stress. In such situations, investors looking for tax-efficiency fixed income like returns and assured interim liquidity near fair value can get attracted to a special category of mutual funds called arbitrage funds.
How do arbitrage funds work?
Arbitrage funds aim to generate returns by capturing spreads between the spot and future prices of the stocks. The gap between the prevailing price of a stock in the cash market and the futures market is referred to as ‘spread’. The fund manager would make larger gains when the spread is larger.
Here’s how the trading happens: the fund manager buys a stock in the cash market and simultaneously sells the stock in the futures market at a higher price. When the expiry of the derivatives contract approaches, the prices in both the markets converge. The fund manager sells the stock in the cash market and buys back the futures. The spread, minus the brokerage and other costs, are the profits for the arbitrageur.
Since the fund manager has simultaneously bought and sold the same stock in the same quantity in two different markets with a view to reverse the positions at a future date, there is no directional risk. Even if the stock prices go up or down, the gains of the arbitrageur are limited to the spreads captured while entering the trade.
How returns of arbitrage funds stack up
The spreads during an arbitrage deal are influenced by three key factors –sentiment in the stock market, prevailing interest rates in the economy and the quantum of money chasing the arbitrage opportunity. Let’s look at each one of these separately in brief.
The sentiment factor: When the markets are trending upwards, more investors both institutional and high net worth individuals (HNIs), want to take positions in stocks using derivatives. That creates many arbitrage opportunities. But if the stock markets are in bear phase and the stock prices are falling, then there are not many arbitrage opportunities. Though, such phases may be relatively short-lived. When markets are moving sideways, with not much activity, they offer muted arbitrage opportunities, other things remaining the same.
Interest rate impact: If interest rates in the economy are on the higher side, then the cost of carry for the derivative traders goes up. In such situations, the derivative prices also go up, leaving higher spreads and higher gains. In a low interest rate regime, the other way holds true.
The quantum of money flow: If too many traders are trying to capitalize on the arbitrage opportunities, then it tends to reduce the spread and vice-versa.
In CY2021 and CY2022, arbitrage funds as a category gave 3.42% and 3.91% average returns, respectively, as per Value Research. Since the beginning of CY2023, up to August 24, 2023 arbitrage funds have given 4.41 percent returns. One of the key factors that explain the current higher returns is relatively high money market yields. Money market yields typically track the very short term interest rates. Reserve Bank of India has raised repo rates by 250 basis points between May 2022 and February 2023.
Impact of taxation
Arbitrage funds are treated as equity funds for the purpose of taxation. Capital gains booked on units of arbitrage funds are taxed at 10 per cent if such capital gains exceed Rs 1 lakh in a year and if the units are held for more than one year. In case the units are held for less than one year, then the capital gains are treated to be short-term capital gains and taxed at 15 per cent. This ensures that the post-tax returns of arbitrage funds are better than the post-tax returns of say liquid funds or similar debt schemes, and work well especially for investors in higher tax slabs.
Are arbitrage funds really risk free?
Prima facie arbitrage strategy appears to be a risk-free strategy. Since the trades carried out on the stock exchange, there is no counter-party risk. However, this cannot be a perfect replacement for any debt product. First, the returns on arbitrage funds can be volatile. When markets enter a bear phase, the returns can be muted. Very short-term investments are best avoided in arbitrage funds. Over the medium term, though, these schemes are expected to offer returns similar to money market returns.
Secondly, interest rates in the economy keep changing and as pointed out earlier, they impact the returns of the arbitrage funds. That may not work for investors who are keen to lock in interest rates for a long period of time. For example, many investors at the current juncture prefer to lock in prevailing interest rates by investing in long-term bonds and long-term fixed deposits.
Does it make a good portfolio candidate?
Despite its limitations arbitrage funds can be considered in a fixed income portfolio if the investor has an investment horizon of more than six months. Investors in high income tax slabs may prefer to invest in these schemes instead of investing in debt funds to take advantage of the tax breaks. But most savvy investors would prefer to restrict their exposure to arbitrage funds to around 10 percent of their fixed income portfolio. They may want to keep investing some of their existing debt allocation to direct corporate bonds, long duration debt funds and credit risk funds.
Arbitrage funds thus can offer some diversification to the investor while improving the overall post tax returns of the fixed income portfolio.
-Team AltiFi
Disclaimer: The contents of this blog should not be construed as tax or financial advice. Readers may seek advice from their tax or financial advisor before making any investment decision.