FMP: A Good Investment in the Present Interest Rate Scenario

Fixed Maturity Plan (FMP) is one of the most sought after debt mutual fund schemes.  Debt mutual funds are ideal investment option for investors with low risk appetite. FMPs are similar to term deposits offered by banks. If we consider the tax adjusted return, FMPs fare better than term deposits, especially during a scenario where interest rates are hardening as at present.  Investors must however, remember that FMPs are not all-season funds and FMPS may fail to generate good return  in an easing or low interest rate scenario. 

What is Fixed Maturity Plans (FMP)? 

Fixed Maturity Plan (FMP) is a close-ended debt fund scheme. They carry a pre-defined maturity period. In close –ended funds, investors can invest only during a new fund offer (NFO) period and exit after maturity only is normally envisaged. The maturity tenure may range from three months to five years. The fund mobilized during NFO gets invested across fixed income securities like money market instruments, government bonds and corporate bonds. FMPs get listed in secondary markets too, but the transactions are very less.  Information document provided by fund houses at the time of NFO contains details of  the proposed portfolio structure and rating distribution.

FMPs and lock in of yield

The special feature of the Fixed Maturity Plans (FMP) is that they lock in the yield for the entire period of investment. This is similar to a bank deposit where the contracted rate of interest remains the same throughout the deposit tenure.  Hence, in a high interest rate environment, the lock in is advantageous and FMP becomes a favorite. 

The Fixed Maturity Plans adopt a buy-and-hold strategy. This strategy enables the investors to lock their funds in debt instruments carrying the prevailing yield in the market. Hence, if the investment is in a high interest rate environment, the return happens to be better compared to the low interest rate environment.  In Indian market, as yield levels are hardening at present, FMPs are good investment option for those who are interested to take advantage of higher rate. If you strongly believe that the interest rate has only started to go up, slice investment over a period of time. 

Fixed Maturity Plans (FMPs) Vs Fixed Deposits of Banks

Fixed deposit offers guaranteed return with specified interest rate

The greatest advantage of a bank fixed deposit is that the customer knows at the time of investment itself the interest rate they will earn throughout the tenure. This is because as per prevailing norms, banks are bound to pay the interest at the contracted rate till maturity notwithstanding the interest rate movements in the market. 

Debt mutual fund investment differs in the above aspect. However, FMPs are an exception. By referring to the scheme information document provided by fund houses at the time of NFO and by assessing the proposed portfolio structure and rating distribution, an investor can make a reasonable judgement of return. For instance, for a two year FMP with predominant investment in AAA rated bonds, an investor can get a reasonable idea of return by assessing prevailing yield for two year AAA rated bonds. Hence, FMPs are loosely comparable to bank FDs in this aspect.

Fixed deposits offer better liquidity compared to FMPs

A Bank fixed deposit can be encashed any time. Though FDs are issued for a particular period, the deposit can be surrended at any time with applicable interest rate for the period for which the deposit ran. Some banks carry a penal provision wherein the applied interest can be 1 or 2 percentage less than the eligible interest rate for the period in case of premature encashment. Even then, the investor will receive full amount of initial investment along with interest.  FMPs are close-ended schemes and are listed in the secondary market. But, FMPs are thinly traded. Hence, if an investors desires to liquidate his investment, investor may have to sell FMP at huge discount. 

Fixed deposit does not face interest rate risk. 

In the case of term deposits with banks, the return is guaranteed and no credit risk is involved. But, bond prices are exposed to two types of risks. They are interest rate risk and credit risk. The price of a bond is inversely related to yields. Thus the net asset value of a debt fund is sensitive to interest rate changes in the market. When a bond matures, the proceeds need to be invested in some other bonds. However, depending on market conditions, the fresh investment may not get the same rate of interest it was carrying. Due to this, NAV undergoes change and the risk associated is called interest rate risk. This case is applicable mainly in open ended debt funds. But investors in FMP need not worry about interest rate risk as the schemes mainly invest in debt instruments with maturity comparable to the tenure of FMP and by holding on to the instrument till maturity. Hence an investor gets returns equivalent to the yields prevailing at the time of investment. 

No credit risk for FD while FMP faces credit risk

Unlike other debt funds, FMPs are not exposed to interest rate risk. But FMPs too face credit risk like any other debt fund.  Credit risk means the inability of the counter party to make interest and principal payments when due.  FMPs invest in debts of counter parties. Hence the returns from FMPs are susceptible to risks associated with credit defaults and rating downgrades on the bonds in the portfolio. However, the credit risk in an FMP is nominal as the investment is predominantly in top-rated AAA bonds. Investors must ensure that the selected FMP invests only in AAA rated bonds by going through information brochure. Investor should always remember that FMP may invest in bonds rated below AAA.  Investors with a higher risk appetite can seek better yields by choosing FMPs that invest in below AAA rated bonds too. 

It may however, be noted that AAA rated bonds too are susceptible to credit risks. A situation of this kind was faced by the investors in India recently, when IL& FS group companies failed in honoring their debts which was originally rated AAA.    

Fixed Maturity Plan (FMP) offers better tax adjusted return compared to FD

When we compare the products in terms of tax adjusted return, the advantage tilts in favour of debt instrument. They derive advantage on account of capital gain tax benefit based on indexation for holding periods more than three years. Indexation enables an investor to take advantage of inflation. The prevailing rate applicable for long-term capital gains (LTCG) on all debt-oriented funds including FMPs is  20% after providing indexation. In the case of FDs, an investor needs to pay tax on income as per his tax slab. Thus indexation helps FMPs to generate higher post-tax returns for maturities over three years. The benefit becomes more for those who are in tax bracket of 30%. 

Let us go through an example to have better clarity. 

Celebratebanking.com readers shall make own researches or seek advice of experts before taking any investment decisions based on the above article. .