The government’s move to do away with tax benefits enjoyed by debt mutual funds (MFs) vis-a-vis bank fixed deposits (FDs) has come as a surprise for the Rs 40-trillion asset management industry.

The last-minute change in taxation triggered a selloff in AMC shares, with the debt fund market leader HDFC AMC dropping over 4 per cent. Shares of UTI AMC and Aditya Birla Sun Life AMC also dropped over 4 per cent each.

“The move is disruptive for us. In the case of debt schemes, indexation benefit has been one of our key selling points. The change will also prove detrimental to efforts being put towards deepening of the bond market,” said D P Singh, Deputy MD, SBI MF.

“There will be no tax arbitrage between bank FDs and debt MFs going forward, which has been one of the key attractions. This could dampen flows into debt MFs. In addition, funds such as the Gold ETF, and any fund of funds that fall into the debt fund category for taxation purposes may also witness a decline in flows,” added Chirag Mehta, CIO- Quantum AMC.

The change in taxation has led to concerns that debt funds, which anyways has a limited number of non-institutional investors, will see a section of investors shifting towards bank FDs. This loss of flows is likely to dent revenues of asset management companies (AMCs).

Trust MF, the only fund house which manages only debt funds, sees the taxation change hurting flows into debt funds in the long run. “There is likely to be no impact in the short term but could impact the ability of mutual funds to attract debt flows in the long term. Incrementally, flows will come into funds who are able to manage their portfolios actively and generate inflation-beating returns for investors,” said Sandeep Bagla, CEO of Trust MF.

Some analysts expect a “moderate to low impact” on revenues of MFs given the favourable debt-equity mix.

“We believe this is moderate to low impact as bulk of the revenue/profitability for AMCs accrues from equity AUMs and non-liquid debt AUMs are neither higher growth nor higher profitability segments,” CLSA said in a report.

The brokerage has pegged non-cash debt schemes’ contribution in total revenue of AMCs under its coverage at 11-14 per cent.

Liquid and overnight funds are referred to as cash schemes due to high liquidity and safety.

The two debt schemes along with shorter duration funds — ultra short duration, low duration and money market — may see minimal impact of the tax change as their investors never really benefited from the preferential taxation. Investments in these products are generally for the short term, whereas the tax benefits kick in post the completion of three years of the investment.

Of the industry’s total debt assets under management (AUM) of Rs 13.4 trillion, Rs 8.6 trillion or 62 per cent of the total debt AUM was in cash and shorter-duration debt schemes in February.

Experts believe debt fund managers can minimise the impact on flows by improving performances of active schemes and cutting down costs of passive ones.

“It will also force debt MFs to work harder on generating alpha, and bring down costs of passive MFs like target maturity funds, roll-down funds and fixed maturity plans (FMPs),” said Somnath Mukherjee, CIO & Senior Managing Partner, ASK Private Wealth.

Feroze Azeez, Deputy CEO, Anand Rathi Wealth expects the taxation change to spark innovation in debt MFs. “AMCs are likely to modify their debt offerings to include equity and arbitrage and therefore bring down the tax payout for investors,” he said.

The new law might have scrapped the long-term capital gains tax for debt funds but hybrid schemes having more than 35 per cent equity in their portfolio will still qualify for the preferential taxation. This 35 per cent equity exposure can be either through equity, arbitrage or both.

Arbitrage strategy is considered as equity for taxation but low on risks as managers run fully-hedged equity positions and generate returns from the differential in the prices of stock futures and the underlying stock.