Markets Remain Volatile Amid Elevated Yields: Why Income Plus Arbitrage Funds are a Strategic Consideration

Navigating Volatility in Fixed Income: Income Plus Arbitrage FoFs Offer a Solution

When markets become turbulent and interest rate signals remain ambiguous, investors face a difficult decision: stay in equity and absorb the market fluctuations or move to traditional debt and accept lower post-tax returns. The concern is not just about current interest rates, but also about their potential trajectory. Geopolitical tensions, particularly those affecting commodity prices like oil, continue to pose a risk. If inflation persists or resurfaces, it could keep yields elevated or even push them higher.

In recent years, the disconnect between policy rates and bond yields has made it challenging for traditional long-duration funds to perform as expected. This has led many investors to rethink their approach to fixed income. One solution is to get exposure to multiple debt funds along with arbitrage allocation, which can reduce concentration risk. Income plus arbitrage fund of funds (FoFs) are one such category.

What are Income Plus Arbitrage FoFs?

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A Fund of Funds (FoF) is a mutual fund scheme that invests in a portfolio of other mutual funds, ETFs, or asset classes rather than directly in stocks or bonds. Income plus arbitrage FoFs combine two components: debt and arbitrage funds. The debt portion is typically invested in short- to medium-duration instruments, while the arbitrage component captures price differences between the cash and futures markets.

Key Advantages

The key advantage of Income plus arbitrage FoFs is diversification both in strategy and execution. By combining multiple debt funds with a 35-40% arbitrage allocation, these funds reduce concentration risk and dependence on any one interest rate view. The arbitrage component adds a market-neutral return stream, which tends to be relatively stable even in volatile conditions. Fund managers actively shift allocations across underlying funds, which can enhance risk-adjusted returns compared to a static short-duration fund.

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Tax Efficiency

These FoFs are taxed favorably for investors in the higher tax bracket compared to pure debt funds. Gains are taxed at marginal rates if held for under 2 years, similar to pure debt funds, and at 12.5% for long-term capital gains after 2 years.

Role in a Portfolio

Income plus arbitrage FoFs are not meant to replace equity or all fixed-income allocations. Their role is more specific. They work best for investors who want to avoid the volatility associated with equities. They can also serve as an alternative to traditional debt funds for those seeking better tax efficiency.

Consistent Performance

Performance data reflects the positioning of these funds. They have not delivered outsized returns, but have shown consistency. Over the past few years, returns have broadly ranged between 5-6% over one year, 8-13% over three years, and 6-12% over five years. In a volatile rate environment, that kind of stability can be valuable, especially for investors with defined time horizons.

"Elevated yields allow the underlying debt funds to lock in good accrual, while the arbitrage sleeve benefits from ongoing market volatility. With active allocation across multiple debt funds and arbitrage, these FoFs can capture opportunities dynamically. In a softening rate cycle, this combination can deliver a more stable and well-balanced return profile than relying purely on duration," said Rajul Kothari, Partner at Capital League.