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HDFC Securities Institutional Research Desk: Report on BFSI - The changing contours of debt financing

Posted On: 2023-03-27 21:47:47 (Time Zone: IST)

Sahej Mittal, Institutional Research Analyst, HDFC Securities and Krishnan ASV, Institutional Research Analyst, HDFC Securities.

In an unexpected post-Budget amendment to the Finance Bill, the Ministry of Finance withdrew the indexation benefits that were hitherto available to debt mutual funds (<35% in domestic stocks). Starting the next financial year, these debt mutual funds will instead be taxed at the marginal tax rate irrespective of the holding period. At the margin, we believe this has structural implications for mutual funds, corporates (NBFCs, HFCs, and other corporates), and a read- across for insurance companies and banks as alternative sources for deploying capital. Our discussions with debt market participants and bankers suggest an arbitrage-sensitive capital pool of INR2trn-3trn. However, given the surge in debt MF inflows in response to this amendment, we expect credit spreads for high-grade issuers to ease in the near-term before widening in H2FY24.

Changes to debt MF taxation: Effective 1st Apr-23, for mutual fund schemes that have <35% invested in equities, the amended Finance Act withdrew indexation benefits by introducing taxation of debt MF investments at the marginal tax rate irrespective of holding period. Currently, long-term debt mutual fund investments (over 3 years) are taxed at ~20% with indexation benefit. Corporates and HNIs are the largest subscribers to debt MFs.

Moderately negative to AMC earnings: Industry debt AUM (ex-liquid) at INR6.5tn forms 16.5% of the AUM mix; however, only 9.6% falls in the medium to long-term category. Investments in liquid mutual funds were already taxable and hence, do not get impacted incrementally. Debt AUM contributes 5-23% to revenues of the listed AMCs in our coverage universe. While we remain constructive on the sector, we expect incremental flows to witness higher competitive intensity. We maintain UTIAM as our top pick with a TP of INR950 (19.5x Sep-24E EV/NOPAT plus cash and investments).

Marginally positive for life insurers: NPAR guaranteed products could potentially garner flows from HNIs exploring long-term investment avenues up to INR0.5mn annually, due to the taxation benefit available under Section 10 (10D) under IT Act, 1961.

Banks - net gainers: The amendment increases the relative attractiveness of banks' term deposits (TDs) as an alternative to debt MFs, particularly in the current interest rate regime, given comparable returns (zero tax arbitrage for debt MFs) and virtually no credit risk. However, the pool of debt MFs (ex- liquid funds) is relatively small at ~4% of bank's total deposits as on Mar-22 to see any meaningful impact on the liabilities side. Corporates (ex-Government) contribute a sizeable pool of TDs to banks - INR25trn (~26% of bank TDs), implying limited incremental flow towards bank TDs.

Marginal impact on NBFCs/HFCs' cost of funds: Higher tax on debt MFs is likely to increase the hurdle rate for subscribers and likely to get passed on to borrowers in the form of wider credit spreads. Our analysis suggests that NBFCs/HFCs exposure to debt MFs (through NCDs) is low at ~4% of their total borrowings and hence, unlikely to materially raise the blended cost of funds. The exposure has come off meaningfully post IL&FS crisis and Covid pandemic (cheaper source of funds through bank borrowings). The surge in debt MF inflows since the announcement is likely to ease near-term spreads for high-grade issuers (AAA-rated) given limited supply of high-quality paper. However, the impact is likely to be asymmetric on NBFCs with lower-tenor assets, given that debt mutual funds were dominant in the 2-3y maturity bucket.

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