India's decision to take away long-term tax benefits for debt mutual funds is likely to weaken demand for longer-duration corporate bonds, eventually leading to higher costs of raising funds, mutual fund investors said on Monday.

The Finance Bill 2023 was amended last week to tax investments in debt mutual funds as short-term capital gains, a move that could strip investors of the long-term tax benefits that made such investments popular.

"Demand for above three-year corporate bonds would be impacted, and we could see some steepening of the curve right from one-year to five-year point, and spreads with government bond yields could see 10 basis points of widening," said Raju Sharma, head fixed income at IDBI Mutual fund.

The changes have taken away the long-term tax advantage these funds had over bank deposits and are likely to push money away from most debt mutual fund products, including corporate bond funds, the investors said.

"Corporate bond products like target maturity funds, actively managed fixed income and other funds which are not (used for) cash management will be impacted," said Radhika Gupta, managing director & chief executive officer at Edelweiss AMC.

‘Severely hamper’

Indian companies had outstanding corporate bonds worth around 41 trillion rupees as on December 2022, while mutual funds held around 4.4 trillion rupees of corporate debt, as of February, according to SEBI.

Though mutual holdings may be comparatively smaller to other long-term investors - mostly banks, insurance companies and pension funds, they trade more actively and provide liquidity to the market.

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"The decision may severely hamper the corporate bond market liquidity... With reduced investment in both passive and active debt MF, the depth and breadth of corporate bonds looks doubtful," said Sandeep Yadav, senior vice president, head fixed income at DSP Mutual Fund.

Fund managers expect mutual funds to focus more on actively managed funds which can allow for higher returns and balance out the impact of higher taxes. "Active funds is something where energies would be diverted from fund management's perspective," said a Mumbai-based fund manager.

Managers also said that post the amendment, inflows in equities will rise, which could also dampen demand for debt funds.

"People will invest in schemes with more allocation for equities. Hybrid schemes will see allotment towards equities being raised to above 35 per cent going forward and is not a good step for the development of corporate bond market," IDBI MF's Sharma added.

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