Sunday, June 23, 2024

The reversal of a hefty tax nudge could deepen our bond market

In the recently passed finance bill, the most vociferously commented-upon change (from the Union Budget presented on 1 February) has been the taxation shift on debt mutual funds (MFs). Predictably, most reactions have been of disappointment, as expressed by retail investors as well as capital market participants (mostly fund houses). Keeping obvious vested interests aside, finance minister Nirmala Sitharaman has actually got this spot on. Not merely from a tax efficiency and fairness standpoint, but more importantly from a market development perspective as well.

To simplify the real import of the change, taxes on all investible debt instruments—MFs, bonds, market-linked debentures (MLDs), bank fixed deposits—have been brought more or less on par. For starters, this is actually almost trivial in its common sense. This is how it has been for equities for a long time. An investor holding, say, HDFC stock—via direct holdings in his demat account, or an equity MF or an alternative investment fund (AIF) or through portfolio management services (PMS)—had pretty much the same tax liability on exit. But the same investor holding an HDFC bond had vastly different tax liabilities depending on his choice of vehicle—a direct bond in his demat account, or as an MLD, or held via a debt MF. The tax difference ranged up to 30% of total returns made from the investment! Fairness aside, it had a larger and more insidious systemic effect—that of constraining the growth of the corporate bond market in India.

Because of this tax arbitrage, debt MFs have ended up becoming vehicles for converting interest income into capital gains, rather than active bond portfolios generating superior investor returns by actively managing credit and interest rate risks. Close to 80% of the assets under management (AUM) of debt MFs today comprise either short-dated sovereign/quasi-sovereign/AAA paper or longer-dated holdings of AAA/sovereign paper intended to be held till maturity—both strategies have minimal interest-rate risk and virtually no credit risk.

A strong Thalerian policy nudge (or rather, shove) of investors to invest in the likes of HDFC bonds via MFs rather than participate directly in the bond market has left this market bereft of any significant retail presence. An overwhelming dominance of wholesale participants and a near-absence of retail investors has meant that India’s bond market has been mono-cultured (with most of the liquidity concentrated in sovereign and a few AAA bonds), slow on innovation (near non-existent derivatives market) and prone to single-sidedness (i.e., all participants on one side, driven by groupthink). The contrast with our equity markets couldn’t be starker: powered by 110 million demat accounts, today retail ownership of Indian equities rivals and sometimes even exceeds that of foreign portfolio investors (FPI) and domestic institutions (like MFs and insurers). In contrast, retail participation in India’s bond market is a fraction of that in most major markets around the world, including ones in Asia.

The tax arbitrage-induced shallowness of India’s bond market has had another particularly undesirable impact: the near-absence of long-tenor corporate bonds in India. Given their open-ended liquidity mandate, MFs are reluctant (and small) participants in this market. The heavy lifting here was done by banks between 2005 and 2013, culminating in a bit of a disaster in the form of the non-performing assets (NPA) crisis of the last decade. Ergo, the only meaningful participants in the market are insurance companies and provident funds—correctly structured for this space, but again exclusively wholesale and one-sided by their very nature. The absence of a large retail investor base tells heavily on the economy. As India rushes to build new roads, ports, airports, etc, it sadly doesn’t have a vibrant enough market to raise capital-market financing for it. There is no lack of appetite. The enormous success of erstwhile tax-free bonds (structured precisely for this use case) was enough evidence that once taxation isn’t a determining factor, there is a market for the taking.

Now that taxes across debt instruments have been harmonized, the old Thalerian shove has been at least partially reversed. The next step for the government should be to look at tax rates. Today, issuers of bonds get a tax break on their interest expenses—at the applicable corporate tax-rate of 21%-25%. Retail investors in bonds issued (and now in MFs that invest in those bonds), on the other hand, get taxed at a maximum rate of 39%-43%. This is akin to a double-tax burden on the same stream of cash flows. Rationalizing this would be another big blow in favour of India’s bond market.

“Gentlemen prefer bonds,” said Andrew Mellon, a banker (and US treasury secretary), in the early 20th century. By rationalizing the principle of taxation on bonds and bond instruments, the finance minister has kick-started a journey in which many more Indian gentlemen (and women) will prefer bonds, which should lead to a vibrant Indian bond market.

These are the author’s personal views.

Somnath Mukherjee is chief investment officer, ASK Wealth Advisors

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