Burdening the bond markets

After making all the right noises about taking steps towards a ‘vibrant, deep and liquid’ corporate bond market, the Budget has delivered a body blow to one of its fast-growing segments — debt mutual funds. Proposals in the Budget hit at the very root of debt funds by rendering popular categories such as Fixed Maturity Plans (FMPs) and short-term debt funds prima facie unattractive to investors.

By changing the definition of ‘short term’, as it applies to debt funds, from 12 to 36 months, the Budget has sharply increased the tax incidence for those who invest between a one- and three-year horizon. This will shoot up from 10 per cent to anywhere between 10 to 30 per cent, depending on the investor’s tax slab. Given that over three-fourths of the investors in FMPs and short-term debt funds are high net worth individuals or corporate treasuries, they may be tempted to avoid such funds altogether. The rationale for the move is to negate the unfair tax advantage that debt funds enjoy over bank deposits. With the interest on bank deposits taxed at slab rates, debt funds have enjoyed a 10 per cent tax; fund houses have been exploiting the significant tax arbitrage between the two products to the hilt. By removing this tax arbitrage, the Centre may want debt mutual funds to compete for investor money on their ability to deliver superior returns or liquidity. While there is no faulting the broad thrust of the logic, it cannot ignore the adverse, if unintended, consequences of the decision for the bond markets. The FMPs and short-term debt funds are hugely popular, managing upwards of ₹2 lakh crore in assets. Rendering the category unattractive in one fell swoop can trigger pullouts, which can be debilitating, not just for the fund industry, but also for the bond market itself. FMPs and short-term debt funds today account for a significant proportion of the transaction volumes in the one- to three-year segment of the debt market. Morever, with insurers interested mainly in long-term paper, and foreign institutional investors focussed on government securities, debt funds have emerged as the primary source of short-term loans to India Inc. If debt funds are taken out of the picture, who will step in to provide similar liquidity and demand in this segment? A good compromise formula would have been to hike the tax rates on FMPs, which compete directly with bank deposits, while keeping open-ended debt funds out of this proposal’s purview. This would have effectively put paid to products such as 366-day FMPs, which were specifically designed to exploit tax loopholes.

The other key problem with this proposal is its retrospective nature. With the higher tax rates on FMPs set to take effect from this fiscal, investors who have already parked money in FMPs over the last three years will now see their withdrawals being taxed at higher rates than they were originally promised. Exempting existing FMP investors from the purview of the new rules, would be essential to reassure the investor community that this government doesn’t plan to go down that path.

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