Fixed Maturity Plan are much smarter option than FD

March 20, 2011   ·   0 Comments

Lesson 7:

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FMPs, as they are popularly known, are the equivalent of a fixed deposit in a bank, with a caveat. The maturity amount of a fixed deposit in a bank is ‘guaranteed’, but only ‘indicated’ in the FMP of a mutual fund. The regulator does not allow fund companies to guarantee returns, and hence the ‘indicated returns’ in FMPs.

Typically, the fund house fixes a ‘target amount’ for a scheme, which it ties up informally with borrowers bAefore the scheme opens. Since the fund house knows the interest rate that it will earn on its investments, it can provide ‘indicative returns’ to investors.

FMPs are debt schemes, where the corpus is invested in fixed-income securities. The tenure can be of different maturities, from one month to three years. They are closed-ended in nature, which means that once the NFO (new fund offer) closes, the scheme cannot accept any further investment.

Since these products are of different maturities, investors have the option of buying schemes that suit their requirements. Since these schemes are closed-ended in nature, investors earlier had to pay an exit load.

These FMP NFOs are generally open for 2 to 3 days and are marketed to corporates and well-heeled, high net-worth individuals. Nevertheless, the minimum investment is usually Rs 5,000 and so a retail investor can comfortably invest too.

Credit Rating and Safety

Various debt issues are rated by credit rating agencies. Depending on the financial health of the companies issuing the debt, the debt instrumented is given a rating that indicates the risk associated with it. FMPs invest in debt having different levels of risk. But they usually stick to relatively low-risk debt issues.

FMPs usually invest in certificate of deposits (CDs), commercial papers (CPs), money market instruments, corporate bonds and sometimes even in bank fixed deposits. Depending on the tenure of the FMP, the fund manager invests in a combination of the above-mentioned instruments of similar maturity. Say if the FMP is for a year, then the fund manager invests in paper maturing in one year.

The prevalent yield minus the expense ratio, which varies from 0.25 to 1 per cent, will be the indicative return which can be expected from the FMP. The expense ratio is mentioned in the offer document. The yield can be indicated fairly accurately because these schemes are open only for a short while.

The fund received is for a pre-specified tenure and the exit load from this plan is high (usually 1 per cent to 3 per cent, depending on the time of redemption). So, the fund manager has the liberty to deploy most of the funds mobilised under the scheme.

The actual return can vary slightly, if at all, from the indicated return. Against that, a bank fixed deposit exactly prints the amount which is due to you on maturity on the FD receipt. However, FMPs do earn better returns than fixed deposits of similar tenure.

Situation 1: When Time of Investment is less than one Year

  BANK FD FMP- dividend option FMP – growth option
Net yield 8% 8% 8%
Tax 33.66% 33.66%
DDT 14.025%  
Net yield 5.3% 6.8% 5.3%

Actually, the dividend distribution tax is deducted on the gross yield. So the return from the dividend option can be 10-20 bps higher.

But for the sake of simplicity, it is calculated here on net yield.  If the tenure of the FMP is more than a year, the growth option gives a higher yield because of the indexation benefit.For less than a year, opt for FMP Dividend option.

Situation 2: When Time of Investment is more than one Year

 

 

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The finance minister has been generous enough to recognise that inflation erodes the real value of any investment. So every year, he comes out with an inflation index based on the prevailing rate of inflation.  The cost of investment is indexed by multiplying the index of the year of maturity and divided by the inflation index prevailing on the year of investment. If you have arrived at an indexed cost, then the long-term capital gain is taxed at 22.44 per cent and if you do not opt for the indexed cost, then the tax is 11.22 per cent.

How does one know of these plans?

As mentioned earlier, these schemes are not advertised heavily and the commission on them is low. But, the good news is that these plans are launched on a regular basis by mutual funds. You may have to badger your MF intermediary for information on them, but it is well worth the effort.

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FMPs, though they offer potential to earn better returns than Fixed Deposits are exposed to two types of risk:

Liquidity Risk

An FMP only invests in securities on a hold-to-maturity basis; once bought, eachsecurity is normally held until it matures. The secondary markets for debt securities is shallow at times. If for any foreseen reason a FMP is forced to sell a security during these times, it may leave limited options for such sale. The risk is called Liquidity Risk.

 

Credit Risk

The return offered by an FMP is entirely determined by the yields on the securities it has invested in. These yields reflects inter-alia in the credit risk of the borrowers – the riskier a borrower, the higher the yield of the borrowers offer their debt.
Investment in any debt contains an inherent risk of the borrower delaying or defaulting their obligations to pay the interest or redeem the debt on the due date. This risk is known as credit risk.

 

In a Nutshell

Fixed Maturity plans are closed-ended debt schemes which are highly tax-efficient and normally offer favourable returns. However they offer no guaranteed return (unlike fixed deposits) and have limited liquidity options. FMPs can be an excellent investment for investors who clearly understand the risks associated with them.

Do you think we missed on something on Fixed Maturity Plans in this Article. If yes, please let us know. Sharing your Views will be really appreciated.

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Rajesh Singla

Rajesh is the founder & CEO of Stockssavvy, Stocks analyst,financial advisor by choice,software engineer by fate,biker,gamer,cricket lover n enthusiastic person. He believes in doing things not just to get by but to get Ahead...

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