Biggest casualty of ending LTCG regime is not debt funds but the debt market

– The largest casualty category are the debt funds. But the entire Rs 20 trillion rupees of monies in debt funds aren’t affected because many couldn’t avail of the current LTCG benefits anyway.

For instance, overnight, liquid and ultra short term funds have always catered to corporates that stayed in these funds for a few weeks to months.

– The ones really hit are the target maturity funds and the Bharat Bond ETFs as well as medium duration funds that invest for three to five years maturity. These were the ones that retail investors, who are wary of equities, sought as well as corporates that have savings to spare. The mutual fund sector estimates that about Rs 4.5 trillion are invested in these funds.

The MF asset management company stocks like HDFC AMC and UTI AMC sold off on March 24 to reflect the likely loss in fees for these companies. On the contrary, banks stock gained on hopes that since the tax advantage that MFs enjoyed over bank deposits has ended, banks will now be able to raise deposits more cheaply.

– The third category of losers are we– the risk averse investors in debt funds- more about this later

– The fourth category are the issuers of debt. Non-Banking Financial Companies (NBFCs) regularly issue two to three year debentures that are bought largely by debt funds. It’s possible that shadow banks may see a slight rise in the interest they have to pay henceforth on their bond raising.

Likewise PSU NBFCs like REC, PFC, Nabard and NHB are also big issuers of three to five year bonds. It’s possible they too have to push up their yields. The impact on yields may not be huge because savings are not moving out of the economy. They may move from debt funds to insurance or banks. Hence, it is possible three to five year bonds suffer higher yields but not the 10-year corporate bonds

– The biggest casualty is clearly the debt market since mutual funds were the only parties that bought and sold corporate bonds in the debt market. Insurance and pension funds and even banks are usually hold-to-maturity buyers. So the vibrancy in the debt market is bound to be hurt if debt funds don’t get incremental money.

Large corporations also worry that rules require companies with more than Rs 10,000 crore exposure to the banking systems to raise 25 percent of their incremental debt via capital markets. But this will get tough as the debt market may see shrinking buyers. So India’s anemic debt market just got more emaciated.

– Retail investors like you and me, who have lost the tax advantage when invested in a debt fund may be lured towards the guaranteed return insurance products and even endowment funds. Some rich retail investors who are already paying premiums over Rs 5 lakh won’t benefit from these insurance schemes. Also, retail investors who are unwilling to keep their savings locked for too long may find the insurance option less attractive.

– The other beneficiary of the removal of the debt fund tax advantage is widely believed to be bank deposits. However, personal finance experts say any migration to FDs may not play out.

Firstly, savings in a bank FD are taxed every year at the investor’s slab rate but the same money invested in an MF gets taxed only when the investor redeems his units. Secondly, gains in the debt fund can be set off against losses in some other funds and hence saving via debt MFs will have an edge over the bank deposit

– As we have already said liquid and ultra short term funds were anyway not availing of the lower capital gains. Even among target maturity and medium tenor funds, it is unlikely all corporates will abandon the debt funds, because the question emerges – abandon and go where.

Yes, these corporates could manage their treasury in-house. This far, they have avoided this and handed their money to a debt fund because of the tax advantage. But fund managers point out that for a company to manage its treasury by itself requires investment in a whole team, something the debt funds are ready to do for as low as 20 basis points, if one uses a direct plan. These experts say, many corporates may continue to stick with debt MFs at least partly and accept the higher capital gains tax when they sell out.

– Ultimately, the biggest loser is not the debt fund but the growth of the Indian corporate bond market. The government may argue that in spite of three decades of tax exemptions, mutual funds have done precious little to develop this market.

The total number of folios (i.e. investors) in the debt market is 71 lakh as of February end, as per Securities and Exchange Board of India (SEBI) data. Of this, if one deducts the folios in the overnight, liquid, ultrashort and low duration funds, the number of folios falls to less than 30 lakh. Hardly, a large number of investors by way of impact, the government may argue.

But the answer is not to throw in the towel. India needs a corporate bond market. The government and regulators need to sit down and think through ways of widening and deepening the bond market. The government, in particular, needs to realise that losing a few thousand crore by way of capital gains tax is well worth paying to create this market. One hopes a rethink will happen.