Budget delivers a last-minute blow to debt investors

Fed delivers small rate hike

The expanding debt market in India has taken a hit thanks to Parliament. The Finance Bill was amended to remove a tax benefit that debt mutual funds had been receiving while also passing the budget.

A mutual fund that has no more than 35% of its assets allocated to equity is a debt mutual fund. Shareholder returns that remain in these funds for at least three years are no longer considered long-term capital gains and are therefore not subject to the investor’s marginal tax rate.

As a result, from a tax perspective, debt mutual funds are now on par with bank fixed deposits. Until recently, if held for at least three years without being touched, they were superior to bank fixed deposits since long-term capital gains were taxed at 20% with the benefit of indexation or 10% without it.

The process of indexation involves readjusting the initial investment value to account for inflation that has occurred from the time of the investment. Due to this, the capital gain on which tax must be paid was decreased.

The indexation table is provided by the income tax division and treats the price level in 2001–2002 as 100. Consider a scenario in which you put $100,000 into a debt mutual fund in 2017–18 and withdrew it in 2022–23. Indicators for 2017–18 and 2022–23 are 272 and 331, respectively. The value of your $100,000 after accounting for inflation in 2022–2023 is therefore 331/272 x 100,000, or 121,691. 2. The capital gain is computed using the assumption that the initial investment was $116,691.

This incentive has since been eliminated for investments made in debt mutual funds after April 1.

Companies, who have been the major users of this asset class, are particularly impacted since they use it to reduce their tax expenses. After paying dividends, taxes, and other expenses, businesses that have excess cash must deposit it somewhere. They don’t instantly return significant quantities of cash to shareholders because they can move swiftly when they spot an investment opportunity by keeping some on hand.

Debt mutual funds have proven to be a practical investment for holding such corporate surpluses since they are comparatively liquid, present a respectable rate of return, and, up until recently, provided a favourable tax rate if held for a minimum of three years.

But, the government has determined it cannot afford to provide such a tax break to wealthy corporations and has removed the tax shelter. Banks suffer setbacks as businesses lose some ground.

Fixed deposits lost their appeal to middle-class savers during the low-rate era that ended only a year ago. Since they provided such low rates of return, investors started looking towards alternative investment options including mutual funds and equity-linked saving plans.

Due to the decreased inflow of deposits, banks did not perform much lending either but did not experience a lending bottleneck. Yet, banks require deposits before they may resume lending. Debt mutual funds were a desirable substitute for bank deposits due to their favourable tax treatment. The banks’ desire for this deposit-eroding tax benefit of debt mutual funds to disappear is understandable.

The government has now approved the banks’ request while also raising taxes on itself. Of course, businesses with substantial reserves will pay more in taxes. The corporate debt market will also be severely impacted by this decision, and even popular debt bundles like Bharat Bond would struggle to find buyers.

For projects with long gestation periods to be financed, a healthy bond market is necessary. Banks are excellent sources of short-term lending since their obligations, primarily their deposits, have quick maturities and should, ideally, be invested in assets with quick maturities. Bonds, on the other hand, provide for arms-length financing and long tenures.

When a project is financed using bonds, analysts, brokerages, and busybodies like Hindenburg all scrutinise the costs. When just bank loans are involved, a few lenders decide on the project’s viability, its reasonable cost, and other factors.

Without tax benefits, a bond market may still grow, but it would take much longer. Bond markets also flourish when the risks connected with bond investments, such as those related to interest rates and exchange rates, are freely hedged via derivatives. However, the government significantly raised the securities transactions tax (STT) on futures and options in the most recent budget, further impeding the bond market’s ability to manage risk and slowing its expansion.