Senior officials claim they did not have an inkling of the government’s decision. As an industry executive put it: “It was pushed through like a routine budget item. If this was announced in the budget, it would have been considered the biggest change in this year’s budget announcements.”
The mutual fund industry and investors in the highest tax bracket have reason to be miffed. One of the most tax-efficient products in the fixed-income space for these investors has lost a key advantage. Despite occurrences such as defaults by issuers and the Franklin Templeton episode that raised questions about the safety of debt mutual funds in the past four years, these products had managed to bounce back. This is because the lower tax outgo in debt mutual funds compared with fixed deposits ensured that there were always takers for these products. All that fund houses needed to do was innovate and package a product that suited market conditions.
For instance, target maturity funds (TMFs) – open-ended debt schemes – were the most popular products before April 1 because of the tax advantage and liquidity.
By taxing capital gains from debt mutual funds in line with the income tax slab of the individual, the government has undermined a strong selling point. From being an all-weather product class, debt mutual funds could now be reduced to a situation-based investment option.
Out of the total assets of ₹40 lakh crore managed by the mutual fund industry, debt mutual fund schemes hold ₹13 lakh crore. Industry officials said about ₹3 lakh crore worth of money in various debt product categories could be impacted by the tax change.
Now, it’s an open game between debt mutual funds and other fixed income securities – whichever product manages to generate those extra returns without loss of capital will attract higher flows. Debt MFs that invest in corporate bonds and long-term securities may stop seeing flows as they no longer offer an advantage over competitors such as fixed deposits. Fund managers said the rule that debt mutual funds must invest at least 10% of the scheme corpus in liquid securities such as cash and government securities gives them less headroom to strive for additional returns by investing in riskier debt.Credit risk funds – a category that bets on lower-rated papers – may regain their popularity as investors with higher risk appetite looking to earn about 200 basis points or 2 percentage points above fixed deposits will consider this product. These schemes, which were once investor favourites, had lost their popularity in recent years because rating downgrades and defaults by select issuers had resulted in erosion of their net asset value (NAV). Till the next bout of defaults and downgrades surface, the product could see demand once again. Rich investors would prefer credit structures offered by alternative investment funds (AIFs).
Corporates, one of the biggest investors in short-term debt schemes, could now shift some of the money to equity arbitrage schemes because of the tax advantages, said industry officials. Short-term gains in arbitrage funds are taxed at 15%. The concern here is that excess flows into these schemes could weigh down returns as arbitrage opportunities between stock and futures contracts remain limited.
Industry officials expect the hybrid product category to benefit the most from the tax changes. Some tax-conscious investors are already considering equity savings schemes, which follow a relatively safer investment strategy of putting money in a mix of debt, arbitrage and equity, as an alternative to debt schemes.
The mix of arbitrage and equity investments amounting to 65% of such a scheme’s corpus ensures that the product is taxed as equity.
Diehard equity enthusiasts have been arguing that the removal of the tax advantage from debt MFs could lead to more flows into stocks. Conventional wisdom, however, says allocating more money to equity only for a tax advantage may not be a sound investment strategy. That said, investing in fixed income will require better finetuning and understanding of liquidity, risk and tax efficiency.
