The Future of Debt Mutual Funds Post-Tax Changes

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The mutual fund investment community received
a shocker last month when the long-term capital gain (LTCG) tax benefit was
withdrawn from debt mutual funds from this financial year.

For the uninitiated, the
investments in debt mutual funds were used to enjoy indexation benefits after 3
years of holding. This was applicable to international funds, gold funds, and
any other funds having domestic equity exposure of less than 65%.

For example, if someone keeps money
in FDs that are offering 8%, the interest income was taxed at the slab rate.
Therefore, at a higher tax slab of 30%, post-tax returns come out to be 5.60%.

On the other hand, the original
investment in debt funds after 3 years was allowed to be adjusted by inflation
and taxed at a flat 20%. Thus, returns on debt funds usually attracted an
effective tax rate of 4-12% depending upon the inflation during the holding
period and the number of indexation years. Thus, the post-tax returns of a debt
MF generating 8% returns were roughly 7-7.5%, a staggering difference of 1.5-2%
per annum over FD returns.

It became a choice of investment
for retirees and conservative investors. With this major change, will debt
funds continue to attract flows? Yes, and I have the following reasons to
believe so:

1. Mutual fund industry will need
to innovate and expand the issuer base to include higher-yielding securities.
This will help in generating higher nominal returns to compensate for the loss
of tax benefits in order to attract demand. This I believe should happen over
the next 1-2 years.

2. Debt MFs still do not attract
tax on accrued gains which is the case in FDs. This delaying of tax payment
helps generate higher returns due to the benefit of compounding over the
delayed tax part.

3. Debt MFs are not subjected to
penalty in terms of lower interest rates irrespective of the time of
redemption. Whereas in the case of FDs, the interest rates are reduced if the
redemption is done before the maturity period. Therefore, even if the redemption
in Debt MFs is done after a few days, one gets annualized returns expected to
be received over the average portfolio maturity (provided everything else
remains constant).

4. There wouldn’t be any change in
the flows of investments in Debt MFs where the intended holding period was less
than 3 years.

In my view, directionally, the
policymakers will remove the tax advantages on all the investment avenues
(barring a few which are nascent and need support) making it a flat structure
for all the asset classes. The asset class prices will adjust to enable higher
potential post-tax returns.

As Benjamin Franklin once said “In this world, nothing can be said to be certain, except death and taxes”

Truemind Capital is a SEBI Registered Investment Management & Personal Finance Advisory platform. You can write to us at connect@truemindcapital.com or call us at 9999505324.