Lock into rising bond yields with FMPs, hold on to them till maturity

Do not compromise on credit quality for high returns, and make sure the fund's tenure matches your investment horizon

In May, investors put Rs 117.08 billion in fixed maturity plans (FMPs), a category of closed-end debt mutual funds. In a rising interest rate scenario, these are attractive products that allow investors to lock into existing yields. Investors, however, need to pay heed to a few aspects when selecting these funds.  

Investors can purchase FMPs during the new fund offer (NFO) period. At the time of investing, they can consult the scheme information document (SID) and learn about the rating of the instruments that the portfolio will hold. Expected returns are not disclosed, but your advisor will be able to estimate them: The current yield-to-maturity of the underlying bonds minus the expense ratio is what investors can expect to earn if they hold them until maturity. Bond ratings also indicate the level of risk in the portfolio. The portfolio is formed after the fund closes for subscription. The fund manager buys debt instruments whose tenures match that of the fund and then holds those instruments until maturity (in other words, there is no churning). 

Suitable for rising rate scenario:  The primary reason for FMPs attracting high inflows is rising bond yields over the past 10 months. Along with sovereign yields, corporate bond yields across rating profiles have also climbed. There is growing consensus that the Reserve Bank of India (RBI) may hike interest rates two times or even more in the year ahead. "Corporate bond yields are trading at attractive levels on an absolute basis. Three-year triple-A rated bonds are trading at around 8.50 per cent while double-A rated bonds are trading at around 9.40 per cent. So, it is a good time for investors to lock their investments to benefit from these high yields," says A Balasubramanian, chief executive officer, Aditya Birla Sun Life Asset Management Company. Since these are passively-managed, long-term, fixed-income products, the investor has reasonable visibility around both the credit quality of the portfolio and the expected return, he adds.

If an investor buys an FMP of more than three years, he becomes eligible for indexation benefit. This will allow him to earn better post-tax returns than bank fixed deposits, which are taxed at the marginal income tax rate. 

While FMPs too experience volatility, the investor does not experience it because he is locked in for the entire tenure. "Their closed-end structure enforces discipline, making investors hold on to them till the end of their tenure. This makes them suitable for those who get spooked by debt market volatility," says Vidya Bala, head of research, Fundsindia.com. Fund managers follow a buy-and-hold strategy in these funds and do not trade in the underlying papers. This, too, makes them less volatile.

Beware liquidity and credit risk: FMPs are illiquid instruments. "Though they are listed on the exchanges, they trade at steep discounts on them," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. Only investors sure of holding these instruments till the end of their tenure should invest in them.  

Some experts feel that the quality of portfolio may be difficult to assess as it is constructed only after the closure of the FMP, and this poses a potential risk. Others, however, disagree. "The fund house will disclose in its SID what proportion will go into triple-A or double-A bonds. That is adequate information for evaluating portfolio risk," says Bala. What is critical, however, is that investors should not bet on FMPs that will invest in lower credit quality papers in the pursuit of high returns. Conservative investors should stick to FMPs that will invest largely in triple-A instruments, while those who have some risk appetite may opt for products that invest largely in double-A rated papers. Anything with lower credit rating should be avoided, given that bond ratings In India sometimes fall by multiple notches at one go.      

Investors who want liquidity and will not get spooked by interim volatility may opt for open-end debt funds whose modified duration matches their investment horizon. For instance, they could opt for a short-term debt fund if they have a three-year horizon. One benefit of buying an open-end debt fund, says Dhawan, is that investors will have the option to exit the fund in case the tax rules change (always a possibility in India).