How can we make investors shift out of debt mutual funds, into deposits with our good old public sector banks? This seems to have been the thought process at the Finance Ministry which led to it plugging the so-called tax arbitrage between debt funds and bank FDs in the recent budget.
Yes, by making capital gains on all non-equity mutual funds subject to 10 to 30 per cent income tax for less than three years and by hiking the long term capital gains tax rate to 20 per cent (with indexation), the FM has brought debt mutual funds on par with their rivals-the bank deposits-on the tax aspect.
But if the government expects this move to lead to a large exodus from debt funds into bank FDs, it may not happen soon. After all, tax isn't the only factor that an investor considers while making an investment decision. He also looks at return potential, liquidity and of course, safety of the instrument. On two of these factors, debt mutual funds, especially of the open ended variety, still score over bank FDs.
Let's take stock of this from the point of view of different classes of investors.
A first category of investors in debt funds are those who seek a parking ground for their surpluses for periods of anywhere between a few days to a year, with the ability to make a quick exit if they need cash. Over one-third of all debt mutual fund assets, over ₹2 lakh crore is parked in such funds.
One segment of this market are corporate treasuries and institutions, who use liquid or ultra-short term debt funds as an alternative to bank accounts.
Now, for this category of investors, liquid and ultra-short term debt funds are certainly better than bank deposits. For one, the funds, by actively playing on short term market rates, manage annualised returns of anywhere between 6 and 8 per cent. This is far better than zero-interest earning current accounts. And two, though they may earn returns that are a little lower than wholesale deposits with banks, they offer superior liquidity, by allowing investors to withdraw at any time of their choice without any loss of returns.
A second segment of this market are savvy retail investors and high net worth individuals who use liquid and money market funds as a substitute for their savings bank accounts. These individuals will continue to find liquid/ultra-short term funds a better bet than savings accounts with banks due to their vastly superior returns. While most Indian banks offer a savings bank interest of 4 per cent (a few offer 6 per cent), liquid and ultra-short term bond funds have managed average category returns of 7.7 to 7.8 per cent over the last five years on an annualised basis.
What is more, the budget tax changes make no difference to any of these investors, as the capital gains they earned for less than 1 year were anyway taxed at their marginal income tax rates. This suggests that they were investing in these funds only for liquidity and returns, and not for tax considerations.
The second class of investors who bet on debt mutual funds are those with 1-3 year money to invest and want to earn a healthy return on this investment. Now these investors can either choose debt fund categories such as short term bond funds, income funds, dynamic bond funds and corporate bond funds or they can go in for Fixed Maturity Plans.
Investors who didn't mind market related risks for higher returns and wanted anytime liquidity would hitherto invest in the open end bond funds.
But traditional bank deposit investors, who can lock in their money and prefer a predictable return over anything else, used to buy into Fixed Maturity Plans (FMPs). For the second set of investors, products like 370 day FMPs were a godsend. While their portfolio returns just about matched the bank deposits of 1-3 year tenure, they delivered much better post-tax returns by exploiting tax loopholes such as the double-indexation benefit.
Now, with the tax edge gone such investors may well flock back to bank FDs which offer predictable returns. But with most market experts believing that interest rates are at a peak, and set to decline over the next year or two, there is scope for the actively managed funds to deliver higher returns than bank FDs over the next 2-3 years. Therefore, for investors who are willing to take on some market-related risk and who like the convenience of anytime liquidity, short term debt funds, income funds and dynamic bond funds still make complete sense.
It is only the 1-3 year FMP investors who were purely in it for predictability and tax arbitrage who will now find it lucrative to shift to bank FDs.
Yes, mutual fund houses are now trying to woo these FMP investors into staying back by offering them extensions and rollover options on their 1 year FMPs, so that they can get long-term capital gains benefits.
But such investors should weigh a couple of factors before making this decision. One, interest rates today may not be the same as those prevailing one year ago. Therefore, given that these FMPs had initially locked only into one-year instruments, they will now have to redeem their older bonds and buy new instruments to rollover their fund. This could change the expected returns on such funds.
Two, by locking into a fixed rate and holding to maturity, such investors would be denying themselves the opportunity to make additional gains by trading on a falling rate scenario. If rates do decline over the next two years, you would expect the actively managed debt funds to outperform these FMPs.
If they weigh these factors, investors who have parked nearly ₹1.8 lakh crore in such FMPs may not move en masse into bank deposits either.
Overall, yes the new tax proposals will chip away at the attractiveness of one small slice of the debt mutual fund industry-the 1 to 3 year FMPs. But savvy investors may still find plenty of reason to seek out the many categories of actively managed open end debt funds.