FOCUS: Tweak in taxes on debt mutual funds may hit corporate bond mkt

Informist, Tuesday, Mar 28, 2023


By Subhana Shaikh


MUMBAI – India's fledgling corporate bond market is likely to become an unintended casualty of the surprise announcement by the finance ministry to withdraw long-term capital gains tax benefit on debt mutual funds, industry players said. The move is likely to hit incremental inflows into debt funds, which are major investors in India's corporate bond market.


The finance ministry last week moved an amendment to Finance Bill 2023, removing long-term capital gains and indexation benefits on income from debt mutual fund schemes. According to the amendment, after Apr 1, investments in debt mutual funds will be taxed at the respective tax slab of the investor.


Currently, capital gains arising from transfer of mutual fund units, other than equity-oriented funds, held for more than three years are considered long term, and are taxed at 20% with indexation benefit.


"Investors may like to stay cautious because this move will cause some decrease in incremental flows," said Shameek Ray, head debt capital markets at ICICI Securities Primary Dealership.


A decline in incremental inflows into debt mutual funds will in turn affect the demand for corporate debt.


"It will hurt the inflows in debt mutual funds, which will eventually push corporates towards bank borrowing," said Sanjeev Churiwala, chief finance officer at Tata Power Group.


According to the Securities and Exchange Board of India, mutual funds held 4.15 trln rupees out of the outstanding corporate bonds worth 41 trln rupees as on Dec 31, 2022.


Merchant bankers believe that this may also push up cut-off yields in the primary market. This is already in play as Power Finance Corp on Friday raised 17.84 bln rupees through two long-term bonds as against 42 bln rupees that it had initially set out to borrow at coupons of 7.66% and 7.70%, 4-5 basis points higher than what market had expected earlier.


Over a period of time, one would see spreads getting re-priced, said a fund manager at an asset management company.


While all debt mutual fund schemes will be affected by the move, those with longer duration funds, which have invested 70% of assets under management in corporate bonds, will be hit more adversely, according to a report by Jefferies.


With the tax advantage gone, many expect there could be some diversion of funds to fixed deposits of banks.


Market participants, however, believe the diversion may not be large as debt mutual funds will still have an edge over bank fixed deposits despite the tax arbitrage going.


"Impact on corporate net debt flows may not be significant, and it is unlikely that a chunk would shift to fixed deposits given debt mutual funds are open ended offering more flexibility and debt fixed deposits would offer a compounded cash flow advantage to fixed deposits, since gains would be taxed only on sale while fixed deposits are taxed each year," broking firm Prabhudas Lilladher said.


Mutual funds also allow setting of short-term losses against short-term gains when carried forward. In the long run, the removal of the tax advantage for debt funds is just another hiccup, market participants said.


"Whenever there are changes, there is a possibility of a near-term impact, but structurally our markets have huge potential to grow," said Anil Gupta, vice-president financial sector rating at ICRA.


"Fresh inflows let's say it was growing by 10%, 400-500 bln rupees that used to come in, is not going to dent the total issuances worth 8 trln rupees happening annually," Gupta said.


Market participants said mutual funds will still be a better instrument for corporates, which are looking for liquidity management.


Corporates account for 55% of the assets under management of 6 trln rupees in long-term debt mutual funds, Jefferies said.


"Corporates which used to put money just because of tax saving and didn't want liquidity and if they find good rates, might prefer certainty of returns that bank fixed deposit offers. There might be some on the fringe, which might lose," a fixed income director at a foreign bank said.


Fund houses are rushing to get investors to invest in debt schemes before Mar 31 to beat the new taxation.


On Monday, S. Naren, executive director and chief investment officer at ICICI Prudential Asset Management Co, said the next four days are a big opportunity for investors to invest in debt schemes.


"The whole mutual fund industry is going all out to get investors to invest in long-term funds before Mar 31, so that they can expand their AUM and use it like perpetual money. This will allow some buffering," the director at the foreign bank quoted above said.


The new tax could affect central and state government securities as well. Mutual funds held 3.23 trln rupees of government securities as of Dec 31, 2022.


Primary dealerships, which underwrite the government's gilt issuances, were expecting mutual funds to pick up about 500 bln rupees of fresh supply of record 15.43 trln rupees in the next fiscal year starting April.


Traders anticipate a 2-3 basis points rise in on-the-run government securities maturing in five, 10 and 14 years, the favoured bonds by mutual funds, after the new financial year kicks in, dealers said.


Until then, dealers expect a large influx of cash into mutual funds, largely from corporate houses parking excess cash before the new tax kicks in.


But the move is definitely a setback to debt mutual funds and corporate bond market, which has become collateral damage of government's effort to plug loopholes in tax arbitrage.  End


Edited by Ashish Shirke


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