Rise in key rates means better returns on FMPs

Investors in debt mutual funds find themselves in a sweet spot each time there is an announcement of a rate rise. Fixed maturity plans (FMPs) especially become more popular because of the tax benefits these offer.

At present, investors in an FMP with an all-bank certificate of deposit (CD) portfolio can expect an annual return of 9.5 per cent. For a portfolio, which includes commercial papers (CPs), the expected returns can be 9.75 per cent.

With the Reserve Bank of India increasing the repo and reverse repo rates by 50 basis points on Tuesday, market experts said returns in an all-bank CD portfolio could rise 15-20 basis points. Similarly, for a portfolio with CPs, the rise could be another 25-30 basis points. For investors, this would translate into returns of almost 10 per cent.

There are tax benefits, as well. That is, there is a double inflation indexation benefit, if the scheme matures slightly over a year. For instance, if one invests in an FMP in May 2011 and it matures in June 2012, there will be indexation benefits for two years — 2010-11 and 2012-13. The net tax rate on capital gains = 10 per cent without indexation and 20 per cent with indexation.

Compared with fixed deposits (FDs), FMPs look quite attractive. It is because although some banks such as Karur Vysya Bank are offering up to 9.5 per cent for one year, the interest income will be added to the total income of the assessee and taxed, according to the slab. Clearly, FMPs score over FDs in terms of returns.

But FMPs are riskier in nature and lack liquidity. Since they invest in CPs, there is a chance of default in bad times. In October 2008, Rs 1.2 lakh crore was withdrawn from these products, amid fears that many fund houses had invested their assets under management (of a single scheme) entirely in a single sector/company or few sectors/companies.

After the panic outflow, the Securities and Exchange Board of India (Sebi) came with strict guidelines where fund houses were banned from giving indicative portfolios and indicative returns. In addition, the listing of FMPs on the stock exchanges was made mandatory.

The latter move has reduced the liquidity of the product. Investors who purchase FMPs and wish to exit in the interim have to sell through the exchanges. Given the secondary market of FMPs is not robust, investors may have to exit at a discount. In comparison, one can pay a small penalty and liquidate the FDs.

In crux, investors need to be careful before buying FMPs. Although the product is tax-efficient, it is riskier and less liquid in nature.