Series of fixed maturity plans (FMPs) have been launched by fund houses in the recent months. These offerings clearly indicate that the FMPs which were once exclusively reserved for corporate and high net-worth individuals (HNIs) are now competing with traditional fixed deposits (FDs) for retail investors` money. With lower risk as compared to equities and other debt funds, FMPs as a portfolio construction tool are often a viable product. In this article, we discuss FMP as an investment avenue, its pros and cons, compare it over fixed deposits and understand why investment into FMPs makes sense in current scenario.
What are FMPs?
An FMP as the name suggests is a mutual fund which has a fixed maturity period and invests in fixed income instruments like bonds, government securities, money market instruments etc. There are a few FMPs which also invest a small portion of their corpus in equities but they are exceptions to the rule. The tenure could be 30, 90,180, 365 days or more and they invest only in such securities that mature on or before the date of the maturity of the scheme. For instance, an FMP with tenure of 370 days will invest only in papers maturing within 370 days or less and hold them till maturity. They are closed ended funds and are listed on stock exchange. Hence, premature withdrawal is only possible through selling on the exchanges or on maturity the units can be directly redeemed from the fund house.
Pros and cons of FMPs
Tax advantage: The returns generated from FMPs if held for more than a year, are taxed as capital gain (10% without indexation and 20% with indexation) instead of marginal tax rate which could be as high as 30%. Also, FMPs enjoys double indexation benefit if held for two financial years. For e. g., suppose an investor invests in a 14 months FMP in the month of March, and holds the same till maturity i.e., till April next year, he would get the advantage of indexing his investment to inflation for two years.
Low volatility: FMPs invest in papers in line with maturity of the scheme and hold the same till maturity; hence they do not carry interest rate risk and provide stable returns with low volatility.
However, FMPs also suffer from certain limitations.
Less liquid: They cannot be pre maturely redeemed from fund houses and the only exit option is to sell them on exchanges, where FMPs do not have enough liquidity.
Less transparent: The returns are neither guaranteed and nor it is known in advance with reasonable certainty. The portfolios of FMPs are also not known before investment and as a result, fund managers may invest in low quality papers to attract higher yields at higher risk. In other words, the investment mandate is not as definitely spelt out as in other mutual fund products.
What are FMPs?
An FMP as the name suggests is a mutual fund which has a fixed maturity period and invests in fixed income instruments like bonds, government securities, money market instruments etc. There are a few FMPs which also invest a small portion of their corpus in equities but they are exceptions to the rule. The tenure could be 30, 90,180, 365 days or more and they invest only in such securities that mature on or before the date of the maturity of the scheme. For instance, an FMP with tenure of 370 days will invest only in papers maturing within 370 days or less and hold them till maturity. They are closed ended funds and are listed on stock exchange. Hence, premature withdrawal is only possible through selling on the exchanges or on maturity the units can be directly redeemed from the fund house.
Pros and cons of FMPs
Tax advantage: The returns generated from FMPs if held for more than a year, are taxed as capital gain (10% without indexation and 20% with indexation) instead of marginal tax rate which could be as high as 30%. Also, FMPs enjoys double indexation benefit if held for two financial years. For e. g., suppose an investor invests in a 14 months FMP in the month of March, and holds the same till maturity i.e., till April next year, he would get the advantage of indexing his investment to inflation for two years.
Low volatility: FMPs invest in papers in line with maturity of the scheme and hold the same till maturity; hence they do not carry interest rate risk and provide stable returns with low volatility.
However, FMPs also suffer from certain limitations.
Less liquid: They cannot be pre maturely redeemed from fund houses and the only exit option is to sell them on exchanges, where FMPs do not have enough liquidity.
Less transparent: The returns are neither guaranteed and nor it is known in advance with reasonable certainty. The portfolios of FMPs are also not known before investment and as a result, fund managers may invest in low quality papers to attract higher yields at higher risk. In other words, the investment mandate is not as definitely spelt out as in other mutual fund products.
FMP vs FD
FMPs are generally used by large investors and companies as an alternative to FDs. Though FMPs do not guarantee any returns, the indicative returns are based on the returns of similar duration bonds available in the market.
The main advantage of investing in FMP as compared to FD is tax arbitrage. For individuals that fall in the highest tax bracket and corporates, the interest on FDs is taxed at 30%. But, if FMP is held for more than 1 year and the investor chooses to treat all the gains as capital gain then he or she will be taxed at 10% without indexation and 20% with indexation. Even if the investment horizon is less than a year, investors can choose the dividend payout option where dividend distribution tax will be at 13.84% for individuals and 22.15% for corporates.
Let us compare the yield for an investor who invests in an FMP versus an FD. Assume that both give a return of 7% for a one-year plan.
As we can see in the above table, even though the pre-tax rate of both the products is same, on post tax basis, the FMP yields 1.4% higher than FD. On the contrary, if FD has to give the same post tax return as FMP, the former has to give pre-tax return of 9%.
Development of FMP over years
After having enjoyed great popularity among investors for some years till 2007, FMPs went through a rough phase in the second half of 2008 and 2009, but now the product is coming back on the radar of investors.
FMPs are generally used by large investors and companies as an alternative to FDs. Though FMPs do not guarantee any returns, the indicative returns are based on the returns of similar duration bonds available in the market.
The main advantage of investing in FMP as compared to FD is tax arbitrage. For individuals that fall in the highest tax bracket and corporates, the interest on FDs is taxed at 30%. But, if FMP is held for more than 1 year and the investor chooses to treat all the gains as capital gain then he or she will be taxed at 10% without indexation and 20% with indexation. Even if the investment horizon is less than a year, investors can choose the dividend payout option where dividend distribution tax will be at 13.84% for individuals and 22.15% for corporates.
Let us compare the yield for an investor who invests in an FMP versus an FD. Assume that both give a return of 7% for a one-year plan.
As we can see in the above table, even though the pre-tax rate of both the products is same, on post tax basis, the FMP yields 1.4% higher than FD. On the contrary, if FD has to give the same post tax return as FMP, the former has to give pre-tax return of 9%.Development of FMP over years
After having enjoyed great popularity among investors for some years till 2007, FMPs went through a rough phase in the second half of 2008 and 2009, but now the product is coming back on the radar of investors.
As we can see from the above chart, from August 2004 to August 2007, assets under management (AUM) of FMPs went up from Rs 44.77 billion to Rs 679.62 billion. Due to the liquidity crisis in October 2008 and the subsequent regulatory changes, the AUM of FMPs fell to Rs 339.66 billion in 2009. However, with several rate hikes by the RBI and short-term papers trading at attractive levels, FMPs are now garnering fresh investments again and the overall AUM for FMPs has reached Rs 654.84 billion in August 2010. In addition to this, around 191 FMPs have been launched in the calendar year 2010 as compared to 76 FMP in the previous year.
Crisis of 2008 and regulatory changes
During October 2008, when the stock market went into a freefall, FMPs faced a huge credit crunch as several risk-averse investors wanted to redeem their FMP investments prematurely. Due to poor quality of papers and illiquidity in the debt market, few fund houses had to put a cap on the FMP redemptions. Also, due to the liquidation pressure on close-ended funds, RBI instituted a term repo facility for an amount of Rs 600 billion to enable banks to ease the liquidity stress faced by mutual funds (MFs) and non-banking financial companies (NBFCs).
Following this, SEBI announced measures to resolve the liquidity problem faced by mutual funds. It banned premature withdrawals in new FMPs launched by Mutual fund houses and compulsory listing of all close-ended products. This meant that even if investors wanted to get out of FMPs in spite of the costs of the exit penalties, the regulator ensured that the investors either sell the units on exchanges or wait till the FMPs matures, rather than asking for an early redemption.
Also, SEBI banned the practice of FMPs declaring indicative future yield and displaying indicative portfolios in advance. Presently, AMCs have to disclose the portfolio of such schemes, once the issue has closed and on a monthly basis on their respective websites. With all these measures, the industry did see some stabilization of AUM in FMPs.
Current scenario
On account of high inflation and reasonable growth, RBI has started tightening the monetary policy and raised policy rates. As a result, we have seen yields on debt papers going up in the last few months. This makes FMPs attractive investment avenue for investors in the mutual fund space, who are looking to park money in fixed income instruments.
Currently, the three-month commercial papers are offering yields in the range of 7% to 7.5% and one year certificates of deposit are providing yields in the range of 7.5% to 8%. So even though FMPs are not allowed to indicate returns, considering the current rate of papers trading in the bond market, three months FMPs could fetch a return of 6.5% to 7.5% post expenses whereas one year FMPs could give return of 7.5% to 8% post expenses.
Conclusion
Taking into account the current scenario of tighter regulation and tax arbitrage, we are of the view that FMPs provide an attractive investment option. With yields at such high levels, it could be a wise call to lock some portion of your fixed income investment at such levels.
However, investors should keep in mind that liquidity is negligible in FMPs so the investor`s investment horizon should be in line with maturity of the scheme. For the final call on selection of an FMP, an investor should look at the portfolios and the track record of the previous FMPs launched by the fund house.
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