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Debt Inflows do not Exactly Turn into a Deluge

Section 14 of the IT Act, which taxes dividend earned on borrowed money, spoils the party for bond funds

The lowered dividend tax on bond funds may have come into effect from June 1 but fund houses aren't exactly celebrating. The dividend tax was slashed from 22 per cent to 10.2 per cent in the budget this year. The new tax dispensation means higher returns for investors and gives bond funds an edge over fixed return avenues. Add to it, debt funds have posted a phenomenal return in the recent past, averaging around an annualised 17% in the last five months. Inflows have also been strong on the back of splendid returns - in the month of May, 22 bond funds have seen a combined investment of over Rs 1600 crore.

Yet, despite a host of positive factors, AMCs do not see a torrent of fresh inflows. For one, a small insertion in section 14 of the IT Act is spoiling the party for bond funds. Introduced last month, the change in section 14 means that those who invest borrowed money in bond funds can now offset the tax-free dividend only to the extent of their interest expense. For instance, a bank earns a tax-free dividend of 9% from a bond fund while paying an interest of 7% on its fixed deposit. Unlike in the past, where banks and FIs were earning a tax-free income of 9%, they can now adjust only 7% against the interest cost while paying tax on the remaining amount (2% in this case). Thus, it translates into a higher tax liability. This is also likely to impact inflows from corporates, which mobilise money from fixed deposits.

"While we will have an aggressive sales pitch vis-à-vis retail investors, we are unlikely to get big-ticket money from companies and banks. The move will impact big funds more, which get a chunk of money from institutions. Thus, we may not see a runaway growth in assets," says the northern sales head of a mutual fund. "Section 14 continues to be a major stumbling block and it is a big problem for corporates. I think this will continue in future,'' says Nilesh Shah, CIO, Templeton AMC.

Two, the recent volatility in the bond markets after the Fitch downgrade and Moody's negative outlook has got investors worried, who fear a repeat of July 2000. Fitch has revised its India rating outlook from stable to negative with concerns on high fiscal deficit, slow pace of reforms and deterioration in the foreign investment climate. Further, Iraq's threat to cut supply of crude oil has pushed up oil prices. Both events could destabilise the forex market and thus impact yields in the bond market.

With the couple of adverse developments, it is likely that the RBI now watches the reaction of the forex market before cutting the bank rate. This could mean further uncertainty and induce selling pressure in bond markets, as players' appetite to hold bonds starts to wane. Gilts have already seen a sharp run up in anticipation of a rate cut with the yield on the 10-year benchmark coming down from 10.12% to 9.79% in just a month. "The current uncertainty could mean further delays in rate actions, certainly not what the market was looking for,'' says Rajiv Anand at Standard Chartered Mutual Fund.

Third, the expected investments from badla financiers have yet to translate into substantial inflows. Although some money did come in May, most badla money is currently flowing into buyback stocks, where the returns are assured. Add to it, there has been a little change in outstanding positions while some badla financiers, having burnt their fingers, are opting for RBI Relief Bonds. "Not much money has come from badla financiers. The outstanding position is still the same on BSE and NSE. At Calcutta, there has been complete inactivity but that's because people have lost money rather than getting it back,'' says Shah at Templeton. Some fund officials also feel that badla money may eventually flow into equities, since badla financiers are more tuned to the stock markets.

The outlook has suddenly turned hazy for debt funds, which have so far witnessed an unprecedented run in the current calendar with eye-popping returns. With little money in equity funds, bond funds have become the mainstay for mutual funds. However, if section 14 continues to be a hindrance and uncertainty in bond markets transpires into a sharp correction, fund houses may have little to offer to investors!