Removal of LTCG tax benefits on debt MFs pushes corporate bond yields

Following govt's latest move, tax would be computed on based the investor's tax bracket; levy could be as high as 30%; Centre's step puts the tax for MF units at parity with that for bank FD

The yields on benchmark 3-year and 5-year corporate bonds jumped on Friday as the Lok Sabha’s nod for the removal of tax benefits for debt mutual fund investors soured market sentiment and led to concerns about incremental demand for corporate debt, traders said.

The House passed amendments to the Finance Bill 2023, according to which debt funds with not more than 35 per cent in equity shares will be taxed at the income tax slab rate, irrespective of the investment period. This removes the long-term capital gain tax benefits currently applicable for investors in debt mutual funds.

At present, if debt mutual fund units are sold after three years, the long-term capital gains tax is at 20 per cent. Following the government’s latest move, the tax would be computed based on the investor’s tax bracket and the levy could be as high as 30 per cent. The Centre’s step places the tax on mutual fund units on parity with that for bank fixed deposits. Given that mutual funds used to buy corporate debt as part of product offerings that offered tax benefits, demand for securities may take a hit. The yield on the benchmark 3-year and 5-year corporate bonds rose 6-7 basis points (bps) in the secondary market on Friday, traders said. On Thursday, the two benchmark corporate bonds settled at 7.81 per cent and 7.92 per cent, respectively, Bloomberg data showed.

“It will take a while for the market to absorb it. Existing investments would not be impacted but there would be an impact on incremental flows after April 2023. Corporate bond spreads should widen. Over the past few years, target maturity funds and other bond funds had brought a lot of secondary market liquidity,” said Rajeev Radhakrishnan, head of fixed income at SBI Mutual Fund.

On Friday, the 10-year benchmark government bond was trading at 7.15 per cent. A wider spread between government and corporate bond yields on account of a quicker rise in corporate debt yields makes fundraising more expensive for firms. So far this calendar year, the yields on 3-year and 5-year benchmark corporate bonds have cli­mbed 16 and 22 bps, respectively. The 10-year corporate bond yield has hardened 11 bps over the same period, the Bloomberg data showed. To evince mo­re interest from investors, fund managers said, MFs would now be under pressure to offer higher returns, given the removal of the taxation benefit.

“A few investors may remain invested wanting to defer tax as tax is payable only at redemption. Incre­mental inflows will come into funds that are able to manage their portfolios actively and generate inflation-beating returns for investors. There is likely to be no impact in the short term but it may impact the ability of mutual funds to attract debt flows in the long term,” said Sandeep Bagla, CEO, Trust AMC.