Two things that stood out in the Union budget were the introduction of the long-term capital gains (LTCG) tax on equities, and the reaction of bond markets to the budget. Besides raising revenue for the government, the prospective introduction of 10 per cent LTCG on equity investments is also a prudent measure. Mutual fund assets under management across equity and balanced schemes have grown by 45 per cent annually in the last three years and have crossed Rs 8.5 lakh crore. As more retail investors enter equities, it is important that they weigh the relative risks across asset classes appropriately, without being swayed by tax considerations alone. To that extent, some convergence of tax treatment across assets was warranted.
As a next step, direct investments in debt securities and bank term deposits should perhaps get the same indexation and long-term tax benefit as investments through debt mutual funds.
While equity markets seem to settle down, the new 10-year benchmark government bond yield moved up sharply by 17 bps to 7.60 per cent. The budget threw up a few concerns for bonds. First, while the government’s focus on the rural sector and farmer remuneration is understandable, the bond market worried about the impact on consumer price inflation (CPI), both through higher food prices and increased rural consumption. Second, some analysts feared there might be more duration supply than was expected by the market, adding to the bond demand/supply mismatch. Third, the market continues to worry that a rise in oil prices may change the fiscal math and push CPI even higher.
The bond market has suffered a series of shocks over the last five weeks –confusion over the government’s extra borrowing programme in the current fiscal, RBI’s admonition to banks on risk management, our dovish chief economic advisor throwing in the towel, and now the budget. With all this, yields have gone up by a staggering 60bps during this period, adding considerably to treasury losses of banks, and raising the cost of funds for the economy.
The bond and swap markets are factoring in rate hikes at this stage, given the prospects of bond supply and hawkish monetary policy committee (MPC) stance. Indeed, as risks
to oil prices, current account deficit, fiscal deficit, and inflation emerge, RBI and MPC have little choice but to remain vigilant
from a financial stability perspective.
However, the run up in bond yields have been too much, too fast. Some relief might eventually come in the form of increased investor interest in debt mutual funds, given attractive yields, and convergence between bond fund and equity tax treatment. Perhaps FPI debt limits might
eventually be increased, though in the current
context, there are implications of this for currency markets and overall financial stability.
In the short run, participation levels of some large banks in the bond market appear to have visibly dropped, adding to bond volatility. Banks, primary dealers, regulators and the government may need to take a deep breath, sit down, and resolve any immediate issues that impede market sentiment and participation.