Tax Treatment of Debt Mutual Funds - Impact on Yields

In the current year's budget, the finance minister has changed the tax treatment of debt mutual funds considerably.  The following image from Economic Times highlights the changes succinctly:

This change, whether or not retrospective, would in effect kill the product FMP - Fixed Maturity Plans - as the sole selling point of the product was tax efficiency.  As Fixed Deposits become on par with FMPs with respect to tax treatment, the liquidity of FDs will overtake FMPs in popularity. 

The impact on Income funds owing to this tax change would not be as directly comprehensible or not as direct.  As per the latest available AMFI data, total investment of approx. INR 165000 Cr is in non-equity category for periods greater than 1 year. As about 90% of the INR 155000 Cr (after adjusting for Gold ETFs and Overseas Fund of Funds) is invested by Corporates and HNIs, it is fair to assume they are sufficiently tax aware and would be making switches for the proportion of investments they intend to hold less than 3 years. 

It is to be noted that corporates and HNIs look for capital gains (owing to price rises or easing yields) over and above interest income - or in other words, their intended holding period of investment and average maturity of the securities in their portfolio need not match: the former being sufficiently shorter. If there is a portfolio level asset shift is made, then a good amount of longer duration securities could be sold. In a nutshell, this could be sufficiently G-Sec and Corporate bond negative in the short term unless Government/RBI enable FIIs to participate in the market as their limits are now completely utilized and they cannot make incremental investments. MF holding of GSec is about INR 40000 CrINR 8000 Cr (based on total GSec+SDL+Tbill amount of INR 50L Cr and that MFs hold 0.17% of that) (Source: Finance Ministry)out of a total outstanding of close to INR 36 lac Crores. Hence, though the impact on GSec market is negative as some sections of  market currently portrays it to be. However, the major negative impact would be on the NCD and Corporate bond market.

The money that is currently in the liquid funds (approx. INR 1.30L Cr) can find their way to Equity arbitrage funds as the latter is treated on par with equity funds - 15% short term capital gains tax and long term capital gains tax of NIL. More importantly, the definition of long term is only 1 year as against the 3Y now for liquid funds. Whether the Equity arbitrage funds can manage to get the same returns with the increased corpus is a different discussion.

Bottomline of the Tax Revision of Debt MF: 

• Mildly Negative for G- T-Bills
• Negative for G_Secs, Corporate Bonds, CPs,and CDs
• Futures premium over spot in Equity might decline and may not be aligned to call rates in the short term.

Update: If there is a sunset clause to this notification, there could be accelerated redemption leading to sharp sell-off in G-Secs. Keep a look out for the Sunset clause, if indeed it comes bond yields can shoot sharply higher - I expect a barbell kind of a redemption pattern: one bout of redemption immediately on announcement and the second bout of redemption close to the sunset date. Sunset date earlier than 2015 would be significantly negative for G-Secs.