It was a short paragraph in Finance Minister Arun Jaitley’s lengthy Budget speech. But those 128 words threaten to change the landscape for investments worth over Rs 7,51,429 crore. In one fell swoop, the Budget has turned on its head virtually everything that your financial planner, investment adviser and this newspaper told you about investing in non-equity mutual funds.FMPs of less than three years no longer have an edge over fixed deposits. In fact, because of their poor liquidity, FMPs are worse than bank FDs. Debt funds are no longer the best place to park your contingency funds. A sweep-in account with a bank will be a better idea.Gold ETFs and gold funds have also lost some of the tax edge they had over physical gold. The only advantages they offer over physical gold are the low transaction charges, assurance of purity and ease of storage.Jaitley said in his speech that “this will hardly impact retail investors as their percentage is very small among such mutual fund investors”. The fact is that there are nearly 67 lakh retail portfolios across all categories of non-equity mutual funds (see graphic).These include MIPs, gold funds and liquid schemes. The impact is already visible on debt funds. After robust inflows of almost Rs 20,000 crore in the first six trading days of the month, debt funds have seen an outflow of almost Rs 8,600 crore after the Budget was presented.This outflow does not reflect the true extent of the disenchantment of debt fund investors because it does not include closed-ended FMPs, the worst hit category which accounts for almost 18% of the total industry AUM.Debt funds have seen massive inflows of nearly Rs 3,70,000 crore in 2014, but analysts fear this could reverse if the amendments sought by the industry and corporate investors are not incorporated soon.There is confusion about the date from which these changes will take effect. Normally, budget proposals are applicable from the beginning of the financial year. Since this Budget was presented after the start of the financial year, making the proposals applicable from 1 April will amount to retrospective taxation.The mutual fund industry wants the new rules to be applicable with prospective effect from 10 July. More importantly, it wants that this should apply only to closed-ended schemes and not all non-equity funds.Though the Budget is yet to be passed and there could be some amendments, the tax arbitrage offered by debt funds will soon be history. Instead of wasting time crying over it, investors should rejig their debt investment portfolios to make it more tax-efficient.“This is not the end of the world. Debt funds have only been brought at par with FDs, not worse,” says Gaurav Mashruwala, Mumbaibased financial planner. Our cover story this week looks at how investors should make changes in their debt investments to reduce the tax outgo. We look at the various debt investments and how they will fare under the new rules.The Budget has extended the minimum tenure for long-term capital gains from one year to three years. This means investors will have to remain invested for at least three years if they want the benefit of lower tax on long-term capital gains.The investors who availed of the ‘double indexation benefit’ by stretching their holding period to three financial years will feel the pinch. Mutual funds used to launch 380-day FMPs in the last week of March. These schemes used to mature in April of the next year, which gave investors the benefit of double indexation.The systematic investment strategies that involved monthly transfers and withdrawals will also need tweaking now. Instead of waiting for one year, the investor will have to start the systematic transfer only after three years if he wants to escape the high tax on short-term gains.However, corporate and high net worth investors who used liquid funds and ultra short-term funds for parking excess cash for short tenures will not have to change their strategies much.“Since there is no tax change for a holding period of up to one year, investors can continue to hold to their liquid and ultra short-term funds,” says Gajendra Kothari, managing director and CEO, Etica Wealth Management. However, the tax liability of dividend option investors has gone up a bit because the government has asked mutual funds to pay dividend distribution tax on ‘gross dividends’, not on ‘net dividends’ as practiced by them now.For the short-term investor who is looking to invest for less than three years, a debt fund is no different from a bank fixed deposit or recurring deposit.“Since there is no tax differential now, the returns should determine the investment avenue,” says Anil Rego, CEO, Right Horizons. Both will get taxed as income at the marginal rate applicable to the investor. Bank deposits could be a better choice only if the investor is looking for certainty of income.Debt funds will be preferred by someone who wants to defer the tax till the time of withdrawal. In case of FDs, tax is payable on the interest that accrues every year. “You have to pay tax every year on cumulative interest on FDs whether you take the money out or not,” says Vikram Dalal, managing director, Synergee Capital Services. In debt funds, the income is taxed only on withdrawal. Debt funds also do away with the problem of TDS.Not much has changed for long-term investors who want to hold their debt funds for more than three years. Their gains will get taxed at lower rates and they can also avail of the indexation benefit. Indexation will take centrestage for debt fund investors now. It has the potential to reduce, if not nullify, their tax.“If you take growth option and hold it for more than three years, the effective tax rates will be very low due to the indexation benefit,” says Jaya Nagarmat, Investor Shoppe.Long-term investors can also gain from capital appreciation in their debt funds if interest rates go down. “If you want higher returns, go for long-dated debt funds,” says Kothari.Bond prices and yields are inversely correlated and any fall in interest rates will push up the NAVs of long-term income and gilt funds. “The potential for gain is more now because the rates are expected to come down in the coming years,” says Suresh Sadagopan, Founder, Ladder7 Financial Advisories. This strategy could come a cropper if the interest rates move up any further from here.Within days of the Budget being presented, mutual funds withdrew more than a dozen one-year FMPs that were scheduled to open last week. They have now been replaced with 3-year and 5-year plans that will be eligible for the lower tax on longterm capital gains. If they don’t want to take the interest rate risk associated with open-ended debt funds, investors can consider 3-year FMPs.“The post-tax return here will be much better than bank FDs,” says Rajiv Deep Bajaj, vicechairman and managing director, Bajaj Capital. However, take this route only if you don’t need the money before three years. Though FMPs are listed on exchanges, they are not traded frequently and, therefore, you may be forced to sell at a significant discount.On the other hand, most banks no longer slap a penalty on premature withdrawals from fixed deposits. It’s a good idea to opt for a two-in-one savings account. In these accounts, if your balance exceeds a predetermined threshold, the excess money flows into an FD to earn higher returns. The money can be accessed any time. Such accounts now seem a better place to park emergency funds than a liquid fund or shortterm debt fund.Tax-free bonds can help The change proposed in the Budget only applies to mutual funds. Capital gains from tax-free bonds listed on the exchanges are still eligible for treatment as long-term gains after a year.Since there is no indexation available here, you can pay 10% capital gains tax. The bonds issued by high-quality companies like the SBI are quoting above 9% yield and may appreciate if interest rates are cut.However, note that the interest earned here is taxable at marginal rates and, therefore, this option is good only for someone in the lower tax brackets.Investors in the high income brackets can consider tax-free bonds. The issuers are highly rated PSUs, so they are very safe. Besides, there is no put or call option here, so you can safely lock in funds for the long term. Bond prices have jumped 14% in the past six months, bringing down their yields to around 8% (see table). The effective yield works out to 12.12% for someone in the highest 30.9% tax bracket.Want a better yield? The PPF can be a good option. This year’s Budget has raised the annual investment limit in the PPF to Rs 1.5 lakh. Investors who have already put Rs 1 lakh in PPF this year can put the additional Rs 50,000 once it is notified by the government. “Investors should take advantage even if the Section 80C limit is exhausted because no other instrument gives 8.7% tax-free returns now,” says Sadagopan.The PPF rate is linked to the government bond rate and may go up or down in future. Younger investors get put off by the PPF because of its long tenure of 15 years. They should start with small amounts now and keep increasing their investments.Despite the hike in the PPF investment limit, some investors will find that Rs 1.5 lakh a year is too low a ceiling. For them, the Voluntary Provident Fund is a good option.Salaried taxpayers covered by the Employee Provident Fund can put more than the mandatory 12% of their basic salary that flows into their PF account every month. Though employers won’t match this additional contribution to the VPF, it still is a good way to save for the long term.The VPF money is added to your EPF account and enjoys the same rate of return and tax treatment. Unlike the PPF, there is no annual cap on the VPF.The Budget has pushed the little-known category of arbitrage funds into the limelight. “Arbitrage fund have suddenly shot into the limelight because of the tax advantage they offer,” says Rego.This is because most of these funds keep their equity investments above 65% and are, therefore, categorised as equity funds. Due to this, the returns from arbitrage funds are tax-free if the holding period is more than a year.These funds only do arbitrage (they buy stocks in the cash market and sell an equal quantity of the same stocks in the futures market at a higher price) and don’t take positional calls. Therefore, they are almost risk-free.Since the Sensex is above 25,000 and there are enough arbitrage opportunities, these funds should continue to generate good decent returns in the coming months as well.However, there is no guarantee that they will continue to generate good returns. There were periods when they generated positive but paltry returns. “It all depends on the arbitrage opportunity available in the market,” says Sadagopan.