Change in Debt Fund Tax Rules: what should you do?

Following up on my previous article of 25^th March (link: https://www.dineshgopalan.com/2023/03/change-in-tax-rules-on-debt-investments.html )

 

The changes will be effective from 1 April, 2023, for all investments made on or after 1 April. What this means is that if you invested anytime on or before 31^st March, 2023, the old rules will apply even if you sell after 1/4/23.

 

Why has the government done this? Debt funds enjoyed an unfair advantage over bank deposits because of their tax treatment. This differential treatment has now been removed. This move was always on the cards – it was not a question of if, it was only a question of when.

 

There are three levels to any investment:

 

 

1.     Protect principal, in other words, the risk element. Investments in government securities are better than investments in AAA corporates are better than investments in other companies and NBFC's are better than investments in risky companies, etc.

 

2.     Protect against inflation. Inflation eats your money away. The "real" return of your investment is the return you get over and above inflation. You hope for at least a zero ( and not negative) real rate of return.

 

3.     Get a real return. The return you get is proportional to the risk you are willing to take, at least in theory. Philosophically, this makes sense, and practically, this is where the whole subject becomes murky and subjective. How do you assess the risk? How do you decide whether the additional returns are commensurate with the additional risk? Anyway, everyone wants to have their cake and eat it too, but in most cases people struggle for their bread!

 

Debt is supposed to protect your principal and protect against inflation. It will never really give you a real return. The real return from debt will always range between plus or minus 2 percent. If it is anywhere above plus 2 percent, you need to be wary – there is likely to be additional risk involved.

 

The options for debt investments are, practically speaking:

 

1.     Bank deposits and 2. Debt mutual funds.

 

We are ignoring PF and PPF in this discussion, since it is not a like to like comparison. Investing directly in corporate or NBFC deposits does give a slightly higher return than the above two options, but at a significantly higher risk, so that route is not worth it.

 

Even when it comes to debt mutual funds, choose only low risk funds which invest in the best quality paper – the extra percent or so that you get from funds that invest in riskier paper is not worth it.

 

All right, now that the tax arbitrage has been removed, what should one do?

 

The entire discussion assumes that the returns from debt MF's and Bank FD's are broadly the same which is broadly true (if you wonder why I am hedging in that statement, well, that is in the interest of being broadly correct!).

 

Advantages of Bank FD's: They are easier to understand.

 

Disadvantages of Bank FD's: You need to decide which bank and what tenor (duration of investment). The decision on tenor is not an easy one. Every time the FD matures, you have to remember to roll it over. Tax  on FD is payable every year, even if it a "cumulative" FD not paying out periodic interest, thus reducing the effect of compounding. If you cancel an FD prematurely, you pay a penalty.  If the Bank collapses, the Deposit Insurance covers you for only five lakhs; this risk can be mitigated by investing in highly safe banks which the government will ensure will not collapse, and by spreading your FD's across banks.

 

Advantages of Debt Mutual Funds: They are automatically diversified, since the investments are in a basket of companies and securities, and you can never lose all your money at once. Once you put the money in, you don't have to track maturity, reinvestment, etc. There is no TDS deduction as in banks, which, in my view, does not matter so much, but it does seem to matter to most people. The "capital gains" on sale can be set off against other capital gains and losses.  You pay tax only on sale, and not annually.

 

So, the answer is clear. Debt funds are the way to go! 

 

Well, but that is only the first step. A few additional pointers, that you need to keep in mind:

 

1.     Do not invest in Funds that invest in riskier paper. The additional one or two percent is not worth it.

2.     There is something called interest rate risk which even the safest of debt funds carry. ( see : https://www.dineshgopalan.com/2023/03/revisiting-investments-and-investing.html ). To avoid interest rate risk, it is better to invest in funds that invest in shorter duration paper, like liquid funds, ultra short, short duration funds, and money market funds. However the interest rate cycle is at or near the peak and this is not a concern for the immediate future. In case it looks like there will be an increase in rates at any point in time, one needs to pull out the investments from Funds that invest in longer duration paper and put them in the above mentioned Funds that invest in shorter duration paper.

 

Huh! I can see you staring at the above paragraph incredulously, thinking – yeh kya tamasha hai, no one tells me all this, and even if they do, I don't understand anything! Kucch samajh me nahin aa raha!

 

Well, I am sorry, but anything can be made only so simple as to make it understandable, but not so dumbed down that the content is lost. The subject is inherently complex, and I do not know of a simpler way to explain it.

 

 

The sum and gist? The advice? You may continue to invest in debt funds, in preference to Bank FD's.  But that still does not absolve you from learning about them and keeping an eye on the market. But then that is true of life in general – nothing absolves you from knowing enough to safeguard your own interests.

 

Non-Finance people can stop reading at this point.

 

For Finance folk: d

 

These changes in rules are for funds that have less than 35 percent equity component. For funds with greater than 65 percent equity, equity rules apply for taxation purposes (15 percent for STCG and 10 percent for LTCG, no indexation).

 

For the funds holding between 35 and 65 percent equity, the rule continues to be: add to income and pay at slab in case of STCG ( less than three years); if greater than three years, that is, for LTCG, twenty percent tax rate with indexation of purchase price is still applicable!

 

Isn't that yummy? Even as a person with a reasonably good understanding of Finance, I find that my head it spinning. It is too early in the day, otherwise I would have poured myself a stiff peg of whiskey.

 

Sigh…

Change in tax rules on debt investments

Starting April 1, 2023, investments in debt funds will no longer be eligible for indexation benefit on Long Term Capital Gains. 

A small tweak, in small print, in the budget. The government proposes, and the government disposes! But the implications for the investors are quite big.

But it is not easy to understand what this means. Understanding that one sentence above presupposes a knowledge of tax laws and of investment options in financial markets.

So, a small primer on the required essentials first. 

1. You have broadly four kinds of investment options ( there are more but these are the primary ones). Equity, debt, real estate, and gold. They are called asset classes. Each of these carries a different risk-return profile.

2. For each of the above asset classes, you can choose to invest either directly or through mutual funds. 

3. Debt mutual funds are mutual funds that invest in debt paper of various kinds, like debentures of companies, bonds, treasury bills, government securities,  deposits, certificates of deposits, money market instruments... The names are many, and confusing, but essentially debt MF's invest in debt paper of the government or of  various companies or financial institutions. They earn interest on their investments and get their principal back on maturity ( hopefully). All these investments are of the form where they can be bought and sold in the secondary market to other investors, meaning they don't have to wait for the redemption date to get money, someone else is always available to buy the debt paper from you.

4. All investors pay income tax on their income. The tax is based on a slab rate from zero to thirty percent. Income consists of whatever you earn, including interest on your debt investments and dividends on your equity investments, and of course your salary, pension, etc. 

5. What about when you invest in equity shares or land? When you sell them you make a profit ( or loss) . Let's say you buy equity shares of Infosys for one lakh rupees and hold them for seven years. Or buy a piece of land and hold it for 7 years. You get dividends on the  shares every year and nothing on the land of course. The annual dividends  are part of your annual income, and they are just added to your income on which you pay tax.  Let's say you sell the shares, or the land,  after seven years for six lakh rupees.  You have made a "capital gain" of five lakhs. How is this taxed? 

If it is "short term" capital gain, meaning you held the investment for less than one year in case of equity and two years in case of land, the sale price minus purchase price, in other words, the gain of five lakhs is just added to your income for the year, on which income you pay tax.

If it is long term capital gain, you pay tax as follows: 

a) Your purchase price of one lakh is "indexed" upwards based on the  inflation in those seven years that you held the investment, based on an "income tax indexation table". Thus your one lakh becomes, say, one lakh eighty thousand.

b) your capital gain on sale is sale price less indexed purchase price, which is six lakhs minus one lakh eighty thousand, which is four lakh twenty thousand. You pay tax at the flat rate of twenty percent of that, and your tax works out to 84000.

6. All investments in mutual fund units are considered "capital " investments, like the investments in Infosys shares or land above. On sale, they are taxed as per the procedure explained in Point 5.

7. To determine whether the gains are long term or short term, in case of equity mutual funds, the cutoff is one year. In case of debt mutual funds, the cutoff is three years. 

Ok, now let's talk about the amendment to the tax law that is effective from April 1, 2023. Go back and read the first sentence of this article. The special tax treatment for long term capital gains on investments in debt mutual funds will no longer be applicable. In other words, when you sell units of your debt fund, your gain, that is sale price minus purchase price, will just be added to your income for the year, and taxed accordingly. 

Still confused? Don't blame yourself, blame the tax laws, they are designed to befuddle us and create a state of brain freeze. Just go back and read the whole thing again. 

Ok, you went back and read the whole thing again. Or you called your  friend the CA and regretted it, for now you are even more confused. I know very few CA's who can explain things to the layman, forget that, they can't even explain things to each other! 

In any case, you read it again , and now you think you understand what I am talking about. 

The next obvious question is, what is the implication for you? 

We will save that for the next article, coming up soon. 

Now, go and have that coffee, or that stiff peg of whiskey, you need it. Reading about tax is always taxing.

Revisiting Investments and Investing

There is no such thing as a risk-free investment.

Holding cash at home is not risk-free since inflation eats the money away.

Investing in a bank involves varying levels of risk:

- the most safe banks are the scheduled public banks. You expect the government to cover losses if the bank fails. Officially , the deposit insurance cover is only 5 lakhs, but in general the expectation is that the government won't allow the bank to go bust. Ditto for most major private  banks.

Safety does not imply solidity. The balance sheets of most banks are suspect.

The risk is that the real return, that is, return net of inflation, may still be negative, especially on a net of tax basis.

As to investing in banks other than the big ones, the less said about it the better. 

Investing in the stock market is highly risky for several reasons. It is a rigged game, where the muppets keep entering only to get slaughtered in hordes. 

Debt mutual funds carry risks as we saw in the case of Franklin Templeton. In search of a little extra yield, they could invest in illiquid  securities of not so strong companies. In case they invest only in 

supposedly safe long dated  government bonds, that carries interest rate risk, which , as the SVB collapse shows, can be deadly. 

Equity mutual funds carry the same risks as investing in direct equity, plus some more. As an individual investor you would never have invested in Anil Ambani's power project or in Nyka. The fund managers, however, are part of a cosy cabal, which believes in mutual scratching of backs, and what the hell, it is not their money anyway.

Every player in the financial markets has an incentive structure that is at variance with the wellbeing of the investor.

The financial markets are a giant suction machine that keep rotating our  money at great velocities, sucking out a little bit in each round, and to add to it, the machine breaks down once in a while.

Gold, as in physical gold, is always safe. It will protect you from inflation in the long run,  but is highly volatile in the short run. However, central banks are scared of gold, in the same way as religions are scared of sex, it is the only power strong enough to threaten their hegemony. So central banks will do everything in their power to curb gold, ban it, demonise it, and in general harass those who hold it. 

Money is supposed to be a "store of value". That is the biggest bullshit fed to us by economists. Economists, by the way, are a totally clueless bunch whose job depends on pretending to be erudite.

An economist consulting a tarot card reader, to raise interest rates, might end up in a better outcome, 

Ditto, an equity fund manager consulting a monkey with a dartboard , to help him choose stocks. 

Cryptos, commodities, options, futures, derivatives, currencies and the like are all  scam games to divest the investor of his money, except that the word investor is inappropriate, hopeful idiots is a better term. In a gambling den, only the house wins. Always.

So then, what to do? 

Money loses value hence one needs to invest in things other than money.

Which things? 

For that, let's go back to the basics of investment.

Anything that will not result in the investor losing his principal. That is the first rule: not to lose the principal.

Anything that is real: that is, is tangible, has a use for someone, and carries real value.

Anything for which the demand from the people will increase over time. Rising demand gets reflected in the price.

Anything that will not collapse overnight, like banks tend to do nowadays.

Anything that has been considered as investment for ages, and will continue to be considered as such.

Anything not subject to black swan events. Black swans seem to be getting  increasingly frequent nowadays. 

Any suggestions? 

Responses are welcome

On food: simple rules, common sense

https://twitter.com/shashiiyengar/status/1634963101853286401?t=J36n50lk4gXy1Cx98nLJ3Q&s=08

Watch the video and be shocked.

The solution is not to have better guidelines and monitoring.

The solution is to cook  food at home, or  order from the neighbourhood auntieji who cooks food at home. 

Avoid all "big chain operations" like McD's , KFC, Dominos, Subway... 

Avoid all processed foods made in a factory.

And then, and only then, go to the next level.

Next level:

Replace refined oil with cold pressed oils.

Replace milk with organic milk, and reduce milk in the diet.

Replace atta with wheat bought by yourself and peesofied in the local chakki.

Replace "table" salt with raw sea salt.

Reduce consumption of white sugar.

Increase organic gud in the diet, by substituting it for sugar where possible.

That takes care of oil, sugar, fat, milk and wheat.

Then, go to the next level. This level is good to have, and depends on affordability and availability.  

Replace veggies with organic veggies.  

Replace fruits with organic fruits.

Then, go to the next level:

Reduce wheat and milk in the diet.

But, throughout, from stage one, continue to have butter, ghee and coconut in the diet. Lots of it.

In parallel: 

Reduce food consumption itself. Eat only "half stomach". 

Have more and more whole foods, less and less carbs, less and less grains, and more and more veggies and fruits. Reduce meat in the diet, and if you eat meat, ensure it is "free range" or "natural" and not from poultry farms or fish farms. Obviously, this means cooking at home since even the best of fine dining restaurants won't follow all this.

If you have allergy issues, or strange stomach problems, first try cutting out milk and wheat from the diet. There is a high probability that the problems will disappear.

In parallel: 

Try and follow the rules of food combination. But that is the subject of a whole separate post, or series of posts. 

Remember, 

The more the food is removed from your direct control or oversight the worse it gets.

The more the food comes from corporates or chains or organisations the worse it gets.

The more the food is commoditised and gets made in industrial kitchens the worse it gets.

The more the deliveries you get from Swiggy or Zomato the worse it gets. 

The more you want "convenience", the worse it gets. 

The more the "western" influence the worse it gets.

The more you follow the advice of your allopathic doctor or nutritionist, the worse it gets.

Each of the above assertions can be the subject of a separate article, but then, why do we need all that?

Common sense should tell you that what I am saying should be broadly correct, and , directionally the way to go. 

The more you go away from common sense the worse it gets.

THE SVB COLLAPSE

So why exactly did Silicon Valley Bank collapse?

They had a lot of money in their current accounts parked at zero percent. All they had to do was invest it in Treasury Bills at say 0.25 percent.

They invested in long dated Mortgage Backed Securities, since they got more return, the exact number is not so important, so let's say  4 percent. 

Now that's a big one. It needs some explanation. What is "long dated" , what is "mortgage backed" etc. etc.

But, before that, what is a bank? A bank is essentially an institution that takes on short term liabilities in the form of deposits, and lends out long term. They lend at a rate higher than what they borrow at thus making a "spread". This spread has to be enough to cover their costs, and bad debts, and yield a profit. 

If they lend long term using money received from short term deposits, they have a problem. If ask the depositors ask for their money back, the bank does not have enough money to repay them. 

Depositors will keep their money with the bank so long as they are assured that it is safe. The moment they feel that the bank is in trouble, they will rush to draw their money out. When more than a particular percentage of the depositors queue up outside the bank, the bank will collapse. Thus, rumour of a collapse becomes a self fulfilling prophecy. 

No Bank in the world can survive a run on its deposits. And every bank lends long term against short term deposits.

The long term securities that SVB loaded up on to make more money on interest , were, from this prospective , thus ok. 

However, they bought long dated government securities with fixed cash flows. Now here's the thing with long tenor bonds. They carry something called interest rate risk. 

What is interest rate risk? Let's say you have a twenty year bond carrying an interest of one percent. And the Central Bank raises the interest rate from one to four percent. Anyone who is investing freshly has a choice. He can buy newly issued  4 percent bonds, or he can buy your bonds at such a price that the "yield" still works out to four percent. Obviously he will pay a lower price for your bonds. 

So, when the Fed raises rates, the bonds that you hold drop in value. Every bank that holds these bonds needs to "mark down" the value of their bond holdings in their Balance Sheet.  This is called mark to market. 

Now, SVB had bought long dates Mortgage Backed Securities, which is an additional problem. The bonds in question were backed by interest payments received from housing loans. Now, when interest rates in the market go up, there is additional stress on people who have mortgages who find it difficult to repay their loans and they can do one of two things: increase their monthly EMI's, or keep their EMI's the same and increase the period of their loans. Obviously, they will mostly opt for the latter. That, in turn, increases the effective tenor of the underlying bonds, which in turn, increases the impact of interest rate increases, which in turn, reduces their price further.

Now, all banks have bonds on their Balance Sheet. They are listed as "Assets". They need to "mark to market" their bonds in the Balance Sheet daily, that is, change the asset values to reflect the current market value. If the value goes up, it's a profit, if the value goes down, it's a loss.

So, that's the background. 

What did SVB do?

SVB had a lot of money parked in their current accounts by depositors at zero percent interest. They could have invested that in 0.25 percent Treasury Bills and their CEO and CFO could have continued playing golf and giving speeches on gender diversity, inclusion, sexual orientation, climate change and the Ukraine war. But what did they choose to do? They of course continued to give speeches on the above subjects - every good US citizen is supposed to do that - but they chose to invest their deposits in long dated mortgage backed securities. 

So far, so good.  Then...

Over the last few months the Fed raised interest rates rapidly. The value of the bonds in the SVB portfolio fell. In their case the fall was steeper since they were all MBS (not Mohammad Bin Salman that great prince villain whose opponents are known to mysteriously disappear, but, you got it, Mortgage Backed Securities). 

Now, SVB needed money. So they sold a large part of their bond portfolio. At a huge loss.  Plus of course, whether they sold it or not, the "mark to market" rule ensured that they "wrote down" their bond portfolio assets, and they suffered a huge loss. This huge loss wiped out their Reserves. They needed to get in additional funds. For which they had to raise equity. Now, they chose a bad time to announce that they needed to raise equity, when there was news in the market of another bank being in trouble. Or, it could merely be the fact that they announced it when the CFO had time between two of her golf matches. We don't know. In any case, the market heard the news, and  what the market heard was "the bank is in trouble". 

So people rushed to transfer their money elsewhere. The rumour spread. More people withdrew their money. 

The share price plummeted - now, that is an entirely different angle, which introduces another dimension. And how the share price plummeted! From around 250 dollars to around 40 dollars. in a few hours. 

Meanwhile, people realised they were not able to withdraw their money. Since the bank had no money.

Who are these people? A lot of them are CEO's of start-ups -  start ups are a special kind of  Ponzi Scheme which is a story for another day - who had parked their hardly earned VC money - oops, that is supposed to hard earned - in current accounts with SVB. 

And the weekend comes. It is Friday evening and the bank people have placed a call to the Fed. The CEO's of the start-ups, are chewing their nails. Everyone is on tenterhooks.

Will the government do it or won't it do it? Do what? Rescue the bank by infusing funds. Whose funds? The taxpayer's funds, obviously. 

We know the answer to that one. If 2008 is any indication. We also know who runs the US government. Wall Street does. As I am about to post this article, breaking news is that the US government has decided to step in and bail out the depositors of SVB Bank. But those who hold equity in the bank or have subscribed to its bonds will be wiped out. Totally.

The CEO's of the start-ups will therefore be able to service their payroll, and in general, continue to burn their VC's money. They are happy. 

The CEO and CFO of SVB will no doubt, meanwhile, release a statement saying:

" We at SVB are a highly ethical bank committed to safeguarding the interests of our depositors and shareholders,  and upholding gender diversity, inclusion, one hundred and twenty five sexual orientations, climate change and we support the government in the Ukraine war".

The headlines in the newspaper tomorrow will say "SVB Bank is not progressive. They support only 125 sexual orientations!"