FMP's facing the heat

The Finance Minister has thrown a googly at the Mutual Fund industry by altering the tax rules for debt funds. For those who have not followed this development, the gist:

Till now, all debt funds held for more than one year were taxed at a concessional rate of 10%, or 20% post-indexation (where the purchase price is indexed for inflation, before ascertaining the gains subject to tax), whichever is lower. As against this, Bank FD's are taxed at full marginal rate (30% if you are in the highest tax bracket). This obviously is an advantage for debt MF's who have been garnering money from the public and lending onward to Banks/ Corporates.

The budget has now changed the rules. From now on, all debt funds held for less than three years will be taxed at the full marginal rate, i.e. be considered short term. This is in line with the definition of short term which is three years for all other capital assets (except equity which is one year). Also, the option of 10% is withdrawn. It will now be 20% post-indexation, like all other capital assets.

Fund houses are in panic mode. Some of them who had collected money recently have returned the money before deploying it. The Fixed Maturity Plans (FMP's), which are usually closed-ended funds specifically formed to take advantage of this tax arbitrage,  especially are going to be the hardest hit. People used to invest in FMP's for a little over a year to get the indexation benefit; and especially around March of every year, to get double indexation benefit, thus enjoying post-tax returns in the region of 9-10%. They are now going to queue up for redemption. And the redemption story is not likely to be smooth. So long as there are fresh flows to replace redemptions, fund houses could "roll over" existing loans, which in some cases could be a case of "evergreening" - allowing rollovers since the corporate is unable or unwilling to repay. It will be interesting to see what happens now. 

Expect some haircuts in FMP schemes, or intervention by the AMC's to bail out the funds.  It all started out innocuously enough with FMP's investing only in Bank CD's and triple A securities of corporates. But then, the race to show more returns soon takes over due to competition, and the asset qualities in the FMP's are not all triple A now. There is also likely to be "swap" of assets from the FMP's to the other debt funds of the same fund house, which may result in reduction in overall quality of the latter.

No financial institution will be able to sustain a run on its assets, where all its depositors queue up to withdraw funds on the same day. FMP's are supposed to be immune to this, since the fund managers are supposed to be investing in ultra-safe debt securities. However, we all like to behave as if the day of reckoning will never come, especially in the financial markets, and assets of suspect quality slowly find a place in the mix.

Industry lobbies are of course gearing up to lobby the Finance Minister. We don't know if he will oblige, and it will be interesting to watch the developments. Meanwhile, if you leave out debt funds (which still offer 20% post indexation taxation, albeit with a three-year lock-in), the post- tax returns on bank FD's are in the region of 6 to 7 percent (for those in the highest tax bracket), which is not even enough to take care of inflation.  On the flip side, there is some justice to the new provision - if you want to enjoy additional tax benefits, the least you can do is to agree to a three-year lock-in. 

( There is no such thing as zero risk - please see also link to a previous article of mine: http://www.dineshgopalan.com/2013/08/nothing-is-without-risk.html )

(Thanks to Ravi Kumar for inputs for this article)