Monday, December 1, 2008

Fixed Maturity Plans - FMP's

Of late people have been talking a lot about Fixed Maturity Plans and how they are better than bank FD's etc. This article is an attempt to introduce you to this investment option.

What are fixed maturity plans?

FMP's, as they are popularly known, are the equivalent of a fixed deposit in a bank, with a little bit of difference. Fixed maturity plans are investment schemes floated by mutual funds and are close-ended with a maturity period ranging from three months to five years. These plans are predominantly debt-oriented, while some of them may have a small equity component.

The objective of such a scheme is to generate steady returns over a fixed-maturity period and immunizing the investor against market fluctuations.

The maturity amount of a fixed deposit in a bank is 'guaranteed', whereas it is only 'indicated' in the FMP of a mutual fund. The regulator for FMP's does not allow fund companies to guarantee returns, and hence they declare only 'indicated returns' in FMPs.

Typically, the fund house fixes a 'target amount' for a scheme, which it ties up informally with borrowers before 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.

How does a FMP work?

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.

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

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 instruments that would be 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 mobilized under the scheme as per his investment decision.

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.

Since FMP's and Bank deposits both invest in debt products the returns earned would be more or less similar. But the FMP's always earn a better return than a Bank deposit. Let us find out how...

The difference maker is in the tax treatment of a mutual fund FMP. FMPs are classified under the debt scheme category and enjoy certain tax benefits, such as:

* Dividend in the hands of the investor is tax-free. But the mutual fund has to deduct a dividend distribution tax of 14.025 per cent in the case of individuals and Hindu Undivided Families (HUFs), and 22.44 per cent in the case of corporates.
* Long-term capital gains (investment of more than a year) enjoy indexation benefit.
* Short-term capital gains are added to the income of the investor and taxed as per his/her slab, whereas the interest on a bank deposit (except where special 80C approved) is added to the income of the investor and taxed as per his/her slab.

The results of all these are quite dramatic.

Let us take an example of a 90 Day FD with a returns of 8% compared to an FMP (Both Growth & Dividend) at the same 8% per annum for an investor who is in the highest tax bracket in India.

Bank FD FMP - Dividend option FMP - Growth option
Yield 8% 8% 8%
Tax 33.66% NIL 33.66%
DDT NIL 14.025% NIL
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.

What is indexation benefit?

Our 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.

A 30 month Bank FD would give us a post tax return of 5.5% whereas a 30 month FMP with indexation benefit would give us approximately 7.7%.

Note: If your investment horizon is short (3 - 6 months) then opt for Dividend option of FMP. If your investment horizon is long (> 1 year) then opt for Growth option to enjoy the indexation benefit.

Factors influencing decision to invest in a FMP

The following are the key factors which an investor must look at before investing in FMPs.

1. Cash flow forecasting: FMPs are suitable for investors who require locking in funds for a particular period of time. E.g. If an individual has a certain cash outflow in three years time, investing in a debt FMP with three year maturity can be considered as the investor is only concerned with receiving the principal plus return on the investment at the end of three years.

2. Immunization of investments: FMPs are a good investment vehicle for investors who are targeting a return on their investments over a fixed period of time and are indifferent to market volatility within that period.

3. Interest rates currently prevailing in the market: The investor should look at interest rates on government bonds, corporate bonds, commercial papers, certificate of deposits, securitised assets, bank deposits, company deposits and other short to medium term fixed income products before taking an investment decision in a FMP. This exercise will give an idea to the investor on the return one can expect on FMPs.

You may be wondering why not so many people are investing in FMP's. All good things have their risks too. FMP's do not come with '0' RISK like the Bank deposits do.

Risks involved in Investing in FMPs

The close ended nature of FMPs does not really protect them against risks including market, credit and liquidity risks. FMPs have the potential for capital depreciation. Investors should take a closer look at the risks in FMPs before making an investment decision. The risks in FMPs are elaborated below.

1. Market risk: Market risk in an FMP is high where there is an equity component in the plan. The fixed maturity nature of the FMP, forces the fund manager to take shorter term calls on equities. This can lead to trading losses as the fund manager does not have the luxury of time to hold on to the investments.

2. Interest rate risk: FMPs are designed to immunize investor against interest rate risk. However, as a plan is launched and money is collected, interest rates can fall before the money is invested and the funds will have to be invested at a lower rate. In such a case the Fund manager may not be able to meet the indicated returns that was declared during the NFO. The non availability of a forward rate market in India is a chief contributor to interest rate risk in a FMP.

3. Gapping risk: If the fund manager is unable to find assets exactly maturing with the plan, this leads to a risk of asset liability mismatch. This risk can negate the immunization of the investment. That is, funds can lie idle with the fund house thereby earning no returns which in turn erodes the final return.

4. Credit risk: Since the FMP's invest in company deposits, the returns on such investment is not guaranteed. Lets assume our FMP invests 10% of its corpus in ABC Ltd and the company declares bankruptcy before the due date, then the amount due from them is wiped off. The fund house would have to manage without this corpus which would eat out on the net returns of the FMP.

5. Terms for large investors: Investors will have to watch out for terms on large investors i.e., if large investors are given zero or low exit loads. This can lead to early exit by large investors from the plan. This will affect the returns on the plan substantially.

Carrying out the above suggested due diligence on a FMP can protect investors from heart aches on wrong decision on FMP investments. FMPs are illiquid and investments can be only liquidated in specific periods. During periods where redemption is allowed, markets may have moved adversely leading to capital loss on liquidation. The load barriers are also quite heavy to prevent pre-mature withdrawals.

So think twice before investing in FMP's. They are not suitable for everyone.

Happy Investing...

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