For long, the tax efficiency of debt funds was tom-tommed rather than the returns they fetched. The tax arbitrage was so stark that fund managers highlighted this point more than their ability to generate alpha.
After the March 24 amendment to the Finance Bill, all that remains in favour of debt mutual funds is that they will enjoy deferred taxation compared to fixed deposits (FD). In an FD, one pays tax on accrual, whether or not the FD is redeemed. With mutual funds, tax will be applicable on redemption, whenever that happens.
Hypothetically, if you invest and not redeem your MF for the next 10 years, you will manage to defer your tax liability for that period.
What happens to target maturity funds?
Target Maturity Funds (TMF) are the newest kid on the block, and many fund houses have launched them in the past few months given that interest rates are at a high, and unlikely to go up much — if at all — from these levels. For those open to locking away their money for 3-5 years, TMFs provided an excellent opportunity.
But with the new debt fund taxation rules, the party is almost over for passive TMFs, as the focus now shifts to actively-managed debt funds. If TMFs reduce their expense ratios to increase their appeal, they will have an extremely difficult time. Of course, deferred taxation is still applicable to TMFs.
Short term pains
The next six months or so would be painful for the MF industry as it aligns with the new normal of marginal taxation. The bigger pain will be borne by corporates who were becoming increasingly dependent on debt funds for their funding requirements. Companies with borrowings greater than Rs 10,000 crore had to compulsorily tap the bond markets for at least 25 percent of their requirements.
Non-banking finance companies (NBFC), who were increasingly reaching out to debt funds for their small- to medium-term needs, will also be hit. The yield curve will steepen and spreads will open up.
The only gainers in this entire episode are banks and the Reserve Bank of India’s Direct platform (for investing in government securities). This amendment has the fingerprints of the banking lobby all over it. Banks have been witnessing a rapid slowdown in deposit growth, partly due to lower rates and partly due to the flow into funds. As banks are by far the biggest participants in the government’s borrowing programme, I am sure the finance ministry did not want to antagonise them beyond a point, despite the bond markets not being deep enough, yet.
But good news is on the horizon. The focus of fund managers and asset management companies will shift to generating alpha and beating FD returns consistently. This will bring direct investment in bonds to the fore and they will now be in direct competition to FDs.
Also read: Indexation benefits on debt funds will go away now
I am sure the finance ministry must have considered this move to fuel bank deposits and ignite credit growth. Continuous flow of deposits is more important in the banking system than anything else, and given the relentless representations by the banking lobby, it was evident the banking system was under immense pressure.
The increase in credit growth in the last few quarters would have also played its part in convincing the government of the need to tweak the tax rules for debt funds.
Going forward, if asset management companies are able to reduce expenses and ensure that debt funds perform better, they will still be a good bet for long-term fixed income investors.
Also read: March 31 deadline for MF nomination gives headache to investors