Investors may feel trapped between a rock and a hard place this year, when it comes to their savings. Inflation remains high, eating away at any gains, and making it a priority to get better returns. Unfortunately, equity markets, which had done so well in 2020 and 2021, are disappointing investors this year.
As interest rates rise and stock markets underperform, many investors are turning their attention to the underdogs of 2020-22 – debt securities. These investments offer stability in returns and tax advantages, providing much-needed relief in today’s volatile global economic environment.
But man proposes, and the government disposes. All investor plans went awry when the finance ministry scrapped tax advantages on debt mutual funds and market-linked debentures from April 1, 2023. Previously, long-term capital gains on debt funds were taxed at a rate of 20%, with indexation benefits.
This meant that the cost of investment was adjusted to the inflation rate, and only the resulting gains were taxed.
Under the new rule, investors will have to pay tax on their capital gains according to their applicable tax bracket. According to the finance ministry, “Many taxpayers are able to reduce their tax liability through this arbitrage. This...has to be addressed.” Finance Minister Nirmala Sitharaman didn’t mince her words while tweeting about the new rule, calling the previous setup ‘revdi’ (freebies).
Social media critics panned the Finance Minister for both her choice of words and the suddenness of the move. They also pointed out that one important factor seemed to have been overlooked: unlike fixed deposits, where investments up to Rs 5 lakh are insured by RBI, mutual fund investors have no such security, and are also exposed to market-related risks.
Reports suggest that the banking and insurance lobby may have played a role in this decision, to increase bank deposits and insurance policies. Whatever the hidden intentions may be, one thing is certain: the investment space is getting a reset.
The aftermath: Which fund categories will get hit the most?
This new tax applies to funds where investment in domestic equities is lower than 35% of assets under management. This means that not just debt mutual funds, but also gold ETFs, international fund of funds, and conservative hybrid funds are under the scope of this change.
Debt mutual funds constitute roughly one-third of the overall AUM of the mutual fund industry. But the entire category won’t be impacted by the new tax rule. Long-term capital gains only come into the picture when mutual fund units are sold after a period of three years. More than 70% of the debt fund category is actually short-term in nature.
Investors can use liquid funds, overnight funds and money market funds to park cash for short periods, while medium and long-duration funds, gilt funds and target-maturity funds are better suited for investment horizons of over three years. As a result of the new rule, roughly 11% of the industry’s AUM is at risk of lower growth.
Asset management companies: Which fund house is at the highest risk?
As the growth of certain debt fund categories is set to stall, AMCs are likely to see a decline in revenue and earnings. Their debt AUM has already fallen YoY in December 2022 due to the rise in bank deposit rates and corporates redeeming their units to pay off debts.
Among the listed AMCs, Aditya Birla AMC has the highest exposure to debt fund schemes, while UTI AMC has the lowest. ABSL AMC is expected to derive over 20% of its revenues from such funds in FY23, but the future growth of this revenue source is now at risk.
The target: Who were the key investors in debt funds?
The bulk of individual investors’ mutual fund assets is held in equity schemes, while institutional investors hold nearly 60% of their assets in debt fund schemes, including liquid funds. Debt funds enable them to manage extra cash at lower risk while exploring other productive uses for their money.
If we consider the investor mix for debt funds excluding liquid, money market and floater funds, high-net-worth individuals and corporates hold most of the assets. These investors fall in the tax slab of over 25% (surcharge applicable for certain corporates).
The ‘revdis’ or arbitrage which the Finance Minister spoke about lies here. Earlier, these investors holding debt funds could earn an additional return of 1.5% over bank FDs due to the lower tax rate and indexation benefit. Their effective tax rate came out to be just 11%.
Note: Tax amount includes an education cess of 4%. Trailing 5-year annual returns are an average of the corporate bond funds with over Rs 1,000 crore in AUM
The investors can’t have their cake and eat it too because the government clearly doesn’t want to let go of this new tax opportunity, which the finance ministry hasn’t quantified yet. But the unintended effect will be that HNIs will opt to invest in funds with higher share of equity.
Debt funds also play an important role in providing liquidity to the corporate bond market, as investors typically do not participate directly. If the inflows in debt funds fall, it won’t be easy for corporates to raise money via bonds. They may have to rely more on banks for their investment and credit needs.
Unless fund managers earn an alpha on debt funds or interest rates go down post FY24, this category may now have limited appeal to investors. If interest rates fall, investors in longer duration funds have a chance to earn handsome capital gains, as bond prices tend to rise when interest rates fall. Funds with higher duration are more sensitive to interest rate changes.
The way forward: What are the alternative investment options?
With debt funds losing their tax advantages, investors can consider hybrid MFs like aggressive hybrid funds, equity savings funds and balanced advantage funds. However, these schemes allocate at least 65% of their investments to equities and derivatives, which may increase the risk factor in an investor's portfolio.
Investors can expect to see new fund offers from AMCs in the category of funds with equity investments ranging from 35% to 65%, which has not been extensively explored so far.
Investors who prefer lower risk can directly purchase listed bonds and non-convertible debentures. While the interest income is taxed according to the investor’s tax slab, capital gains on NCDs sold after one year of purchase are taxed at 10%. The catch here is that the investor has to do due diligence before choosing the security, as there is no fund manager involved.
The new tax rule applies to Gold ETFs as well, which were previously considered tax-efficient and transparent in capturing the movement in gold prices. As an alternative, investors can now consider sovereign gold bonds that offer tax-free long-term capital gains, if held till maturity. Only the interest receipt is taxable according to the slab.
Now let’s address the elephant in the room – Bank FDs. For senior citizens falling in the lower tax slabs, FDs can give 6.5%-7.5% p.a., which can narrowly beat inflation. But for anyone else, money will only lose its purchasing power over time.
In an era where growth is moderating, inflation is high and credit is costly, it is crucial to grow your savings at a decent rate. However, there is no one-size-fits-all approach to investing. Hence, design your portfolio in a way that your future goals, your risk appetite and economic factors are in harmony.
This analysis by Trendlyne is meant for investor education - to help understand companies and make informed investment decisions on their own. It should not be considered an investment recommendation.