Retail investors in Mutual Funds get short end of the stick

Measures proposed in the budget could actually discourage retail investors from parking their surpluses with debt mutual funds.

Whatever it’s other shortcomings, the maiden budget presented by the Modi Government had several measures that were middle-class friendly. The increase in personal tax slabs, the higher tax breaks on home loans and the expanded Section 80C limit for investments, all speak of a government that is keen to ease the burden on the taxpayer and promote financial savings by households.

But the proposals to sharply hike capital gains tax on non-equity mutual funds strike a jarring note in this context. Measures proposed in the budget could actually discourage retail investors from parking their surpluses with debt mutual funds, reduce returns for vulnerable classes of investors such as senior citizens, and impact the development of the nascent corporate bond market.

Not just corporates

By lengthening the definition of ‘short term’ as applied to debt mutual funds, from 12 to 36 months and by hiking the long-term capital gains tax rate on these funds from a flat 10 per cent to 20 per cent (with indexation benefits), the budget makes debt mutual funds unattractive to all savers, who use them to park money for up to a three-year horizon.

The motive behind this move is clearly to do away with the ‘tax arbitrage’, which exists between bank deposits (where interest is taxed at the investor’s slab rate) and debt mutual funds (where returns are taxed as capital gains). The argument is that, as debt mutual funds are being used mainly by corporate treasuries and institutional investors, they should not be allowed to reap undue gains from the tax arbitrage.

But the truth is that debt mutual funds, specifically categories such as Fixed Maturity Plans (FMPs) and short-term debt funds, have been gaining ground rapidly with retail investors in the last couple of years. These investors do not account for a large portion of debt fund assets, but they are certainly large in number.

Data from the Association of Mutual Funds in India show that as of March 2014, debt mutual funds put together managed 58 lakh retail investor accounts. That number is up from 39 lakh accounts three years ago. Though retail investors accounted for just 7 per cent of the assets managed by debt funds, they made up 88 per cent of the investor accounts!

Now, with the equity markets proving quite volatile and debt instruments such as bank deposits offering a 7-8 per cent post-tax return, retail investors have thronged to debt funds because they have managed a better ‘real’ return, in times of high inflation. Products such as FMPs and Monthly Income Plans have been particularly popular with savers seeking a predictable return, particularly the retired and the senior citizens. Isn’t this trend worth encouraging, given that debt funds promote financial savings over alternatives such as gold and real estate?

Bond market upheavals

Even if plugging the tax arbitrage was the main motive, the retrospective nature of these proposals is a particularly unkind cut. With the budget making the new tax regime effective from this very financial year, investors who have already locked money into FMPs, short-term debt funds or Monthly Income Plans in the last two years, will now be forced to shell out a 10-30 per cent tax which they never anticipated, on their returns when they redeem their units.

Apart from causing needless heartburn to these investors, this could trigger avoidable upheaval in the mutual fund industry and bond markets. At last count, debt mutual funds managed Rs.4.60 lakh crore in assets. Industry estimates suggest that about Rs.2 lakh crore out of this is 1 to 3-year money which is most affected by the budget proposals. If corporate and high net worth investors decide to pull out these funds due to the adverse tax regime, this could trigger a liquidity crunch, especially in the corporate bond segment of the debt market. Mutual funds have been active participants in the 1 to 3 year segment of the corporate bond market, and this segment can certainly do with better liquidity and more participants.

In sum, the budget proposals on non-equity funds seem to run counter to the broader policy objectives of this government and are crying out for review. Doing away with the retrospective effect of these measures is the bare minimum that investors would expect. If the government is keen to level the playing field between debt funds and bank deposits, reducing the tax rates on the interest from bank deposits would be a far better way to achieve this objective, without hurting retail investors in the process.

aarati.k@thehindu.co.in