Melt-down of Market-linked debentures, Debt mutual funds get fatal blow

No grandfathering for MLDs, prospectively, tax benefit for debt mutual funds goes away

-Vinod Kothari and Aanchal Kaur Nagpal

finserv@vinodkothari.com

As expected, the Finance Bill, 2023 was passed on March 24, 2023 by Lok Sabha within minutes. With a huge amount of changes including several newly inserted provisions, the so-called amendments were actually a Bill in itself, minus any “notes on clauses” or “memorandum of delegated legislation”, and given the amending document that refers to page numbers and line numbers of the Bill, it is a hard to read document, more so to realise the long term impact it has for the capital markets.

For capital markets, the amended Bill confirms that there will be no grandfathering for market-linked debentures (MLDs), as it specifically provides for a grandfathering only for debt mutual funds. Thus, the future of an approximately Rs. 20 lakh crore non-equity-oriented mutual funds in the country^[1], going forward, will be questionable.

Market-linked debentures in a melting-down mode

We have earlier covered^[2] the Budget 2023 proposals for MLDs, and the impact that the change will have. Due to the absence of a grandfathering clause, the amendment is inherently retrospective as well as retroactive. This is because the amendment applies to returns on MLDs that have already been issued which were invested in with a presumption as to a particular tax effect. A retroactive tax nabs investors, leaving them without any choice of readjust their investment decisions.

In reaction to the increased tax rate on MLDs (from 10% under LTCG to taxation at slab-rates in all cases), some NBFCs have decided to redeem, particularly those where 12 months are over, and some have decided to stay with the MLDs already issued. However, it is quite clear that the market for MLDs is now completely over.

Based on discussions with market participants, we found that companies are trying to grapple with various options to recuperate:

1. Conversion of MLDs to NCDs: This will lead to a change in the entire structure of the MLDs, along with regular interest servicing etc. Further, once out of the scope of MLDs, the debentures will be treated as plain vanilla NCDs, where the benefit of LTCG can be availed.

2. Early redemption/ buyback:

From April 2022 to December 2023, MLD issuances amounting to approximately Rs. 16,000 crores were added to the already existing issuances. However, considering that STCG in the case of MLDs under the existing tax regime, is the same as that of the post-budget tax regime for all MLDs i.e. tax as per slab rates, the benefit of redemption for lower taxation (LTCG of 10%) would only apply to MLDs which have completed 1 year. However, we observed that Companies with MLDs completing less than 1 year are also considering early redemption.

Such redemption can be done either through the exercise of a call option, if provided for in the issue terms, or through early redemption/ buyback.

The SEBI NCS Regulations^[3] however, do not allow a call option to be exercised unless the debentures complete 1 year from the date of their issue. Further, such MLDs completing less than 1 year if redeemed would partake the nature of a money-market instrument requiring compliance of applicable guidelines applicable thereof. This may, therefore,  eliminate MLDs completing less than 1 year to use these options and investors may have to continue carrying the weight of these MLDs.

In any case, issuers may seek early redemption by invoking the material modification provision under regulation 59 of the SEBI Listing Regulations and seek stock exchange approval (along with approval from the DT and the debenture holders). While some companies have been able to obtain stock exchange approval, however, it may have to be seen how SEBI reacts to such modifications.

3. Warehousing in a group company to take-over the burden off the investors leading to the Company absorbing the loss of differential taxation.

Debt-oriented mutual funds worse than any other long term investment

The FM has shocked everyone by including debt oriented mutual funds also in the same category as MLDs. Going by the language of ‘specified mutual funds’ as used in the Bill, all mutual funds, where the equity component is within 35%, and therefore, the debt component is 65% or more, will now be mandatorily taken as short-term capital assets, irrespective of the tenure.

Mutual fund units, unlike equity shares, did not have a preferential 12 months’ holding period for being entitled to “long-term capital assets”. That is to say, in case of mutual funds, it will be 36 months’ holding period, as is the case with any other capital asset.

Therefore, a fixed maturity plan will typically be structured for >36 months period, to qualify as a long-term capital asset, and be eligible for indexation benefit as well as lower tax rate.

With the change introduced by the Finance Minister, even with an over 36 months’ holding period, a debt mutual fund will still qualify as a short-term capital asset. This should apparently be surprising because even a debenture, held for more than 36 months, becomes a long-term asset. If the apparent justification is that a debt mutual fund is indirectly investing in debt securities, there does not seem to be a reason to put a mutual at a comparative disadvantage over direct investment in debt.

In case of mutual funds, the saving grace is that the grandfathering is clear and conspicuous. But a prospective damage is still a huge damage, to an institutional investment which was responsible for flow of debt to corporate sector, municipalities, etc.

Not only will the debt mutual funds be impacted, going by the language of the amendment, several other funds, which do not have equity focus, will get hit by the amendment. Principally, international equity funds, index funds, ETFs, etc. will also be impacted.

Institutional products such as overnight funds, short duration funds are normally not for a term of 36 months or longer -therefore, they were anyways short-term products. Hence, the brunt of the change is mostly on those non-equity funds which were structured for longer than 36 months.

The aggregate mutual fund industry has an AUM of about Rs 40 lakh crores, of which equity schemes take about Rs 15 lakh crores, short-term funds will be Rs 5 lakh crores or so. The rest of the funds may potentially not be having domestic equity focus, as they may be either ETFs or may be hybrid funds. The exact data of the likely damage, therefore, is difficult to assess right now, but the amendment certainly does not bode well for India, at a stage where corporate liquidity is a serious concern. Fixed deposits will relatively become better, but the question remains – is this the policy objective?

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^[1] Net assets under management as on February 28, 2023 (Authors estimates). Source: https://www.sebi.gov.in/statistics/mutual-fund/mf-investment-objectives.html

^[2] Our detailed write-up on the change in taxation on MLDs has been discussed here – https://vinodkothari.com/2023/02/marked-linked-debentures-is-it-the-end-of-the-market-for-them/

^[3] As per regulation 15(5) of the SEBI NCS Regulations, No such right (call or put option) shall be exercisable before the expiry of one year from the date of issue of such non-convertible securities.