By Somnath Mukherjee
It’s been the non-proverbial Ides of several months now for the credit markets. It started with the IL&FS default last year, but it has been a series of blow-ups since then — the latest being downgrades in two Reliance ADAG group companies.
The most immediate impact has been on certain debt mutual funds (MF), that have been large investors in several companies that have come under stress. The most debilitating effect though isn’t about drop in prices — after all MFs are market instruments and subject to price volatility — it is about the absolute lack of liquidity in bonds that come under stress. Given that MFs, for most parts, are open-ended vehicles (i.e., unitholders have a right to withdraw their investments on demand), it is the appropriateness of MFs investing in a class of instruments that are fundamentally illiquid (or suffer from illiquidity the moment there is a stress situation with the issuer).
While there are several reasons why there exists such mismatches in the asset-liability profiles, and in some cases even inappropriate choice of investments of some MFs, the biggest reason has been what can be termed as a Fiscal Nudge – a massive tax advantage enjoyed by the debt MF structure against most fixed income instruments.
It’s important to understand the tax structure governing fixed income in India. Coupons in virtually every fixed income instrument in India – fixed deposits, non-convertible debentures (NCDs), perpetual bonds, government securities (G-Secs) – are usually taxed at marginal tax rate applicable to the investor ( around 34% at the highest tax bracket).
Capital gains, accruing to investors if they sell their bond holdings before maturity at a higher price to their acquisition price, are taxed at lower rates. However, coupons typically represent the bulk of the total returns made by the investor (in some cases, like FDs, they represent 100% of the returns, as FDs are not tradable). Wrap the same bonds within a debt MF, and voila, the tax treatment on total returns to the investor becomes 10% as long as the investor holds on for three years.
The implications for most investors become quite clear. If someone wants to build a low (credit) risk portfolio comprising G-Secs, he is disincentivised from doing the most efficient thing – buy a bunch of G-Secs directly, because if he does so all the coupon payments will be taxed at a high marginal tax-rate. Instead, he is incentivised to buy an MF investing in G-Secs, which reduces his tax liability to a low 10% if held for 3 years.
Now, the example above is a pretty “safe” case – for investors. G-Secs don’t have credit risk, they typically are extremely liquid, and MFs offer as much operational convenience as buying G-Secs directly. Issues arise out of development of market motivations and greed down the credit chain. G-Secs, for obvious reasons, offer the lowest yields. Debt MFs, in order to enhance returns invest in lower-rated corporate bonds as well. Generally, with high levels of disclosures mandatory with MFs in India, it should not be an issue. However, the bond market in India is highly skewed on liquidity — not only are vast numbers of corporate bonds extremely illiquid, many reasonably liquid bonds too turn totally illiquid at the first sign of stress in the issuer of the bond. Fundamentally, this causes asset-liability mismatches for the MF. Further, it gives rise to issues around the fundamental tenet of investing, ie, valuation. Because large numbers of corporate bonds are illiquid, there is no market-level price discovery for these bonds. For such bonds, MFs use a theoretical model price basis a valuation protocol run by an independent third party, CRISIL. As a result, price signals are not always efficiently captured in the NAV. When some bonds in a fund’s portfolio do not reflect the true value in the NAV, investors who stay invested end up subsidising those who exit. In short, a bit of a perfect storm.
Generally, MFs have been imagined as collective investment vehicles for retail investors to participate in the capital markets. Barring specific exceptions, MFs are not meant for pooling in complex, or super high-risk or illiquid instruments. So, it is quite egregious for MFs to have holding company debt, collateralised by single shares (usually of the sponsor/promoter), in most MF portfolios. Ditto for investments into lower-rated instruments that have structural liquidity issues from inception.
However, it is done because the issuers of such instruments do not find a pool of final investors directly, even though there is a large pool of sophisticated, high-net worth investors today. The reason is simple – these investors find direct investing to be highly tax-inefficient, given the tax structure. Ergo, the demand pull to wrap these papers in MF structures. Unfortunately, given any lack of gating of investor-type at MF level, this also means that these complex investments end up being as much in retail investor portfolio as they are in sophisticated, HNI portfolios.
Richard Thaler got a Nobel Prize for the Nudge Theory – basically how policy measures can provide a gentle nudge to the intended audience towards desirable outcomes. Inadvertently, the differential tax treatment of MFs in the wider fixed income universe has provided a nudge towards a different, undesirable outcome of making a taxsheltered, retail investor instrument prone to taking very high levels of risks. Policymakers need to apply corrective nudges to reverse the trend!
(The author is the managing partner at ASK Wealth Advisors)