Yashwant Sinha's proposal to increase dividend tax on debt schemes from 10% (at present) to 20% is a recipe for disaster as far as monthly income plans (MIPs) are concerned.

The move to hike dividend tax to 20% (effective tax rate 22%) has come as a rude shock to many private mutual funds (MFs) who had outlined plans to make a foray in the MIP segment. Templeton Asset Management Company (AMC) was the latest to launch its MIP, and others waiting to unveil their MIPs include - JM MF, Prudential ICICI MF, Sun F&C MF, Dundee MF, ANZ Grindlays and Tata MF.

These MFs are now confronted with the Herculean task of coming out with a scheme to match returns from post-office schemes. For instance, to declare 11% dividend on their schemes, MFs will have to earn a pre-tax yield of 13.4%. This level of return seems unlikely from investments in high safety (AA+) paper. Fund managers in a bid to shore up returns may resort to a higher equity component, which runs against the very nature of a debt scheme.

Equity fund manager aren't exactly thrilled with the budget either. 54EA/EB (capital gains), which was a big incentive for investment in MFs, has been replaced. As reported by a leading financial daily, Hemant Rustagi of ING Barings opined that bigger players will be affected more adversely by the budgetary provision. For instance, while 54EA/EB accounts for 6% of total inflows in ING, they account for 20% of inflows in DSP Merrill Lynch MF. Arun Ohri of IL&FS feels that 54EA/EB account for 1/6th of total MFs inflows.

54EA/EB with the lock-in period checked outflows and allowed fund managers to invest in long term investments to hedge their risks. It also reduced redemption pressure and allowed fund managers to plan more clearly. With the replacement of 54EA/EB, fund managers will have to realign their strategies drastically. This could have an adverse impact on the quality of returns of growth schemes.

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