Want to lock in current high yields? Why an FMP works better than an FD

However, with so many companies facing credit-related issues, opt only for portfolios where the bulk of securities have AA and above ratings

Santosh Mishra, 47, a Delhi-based Supreme Court lawyer, wished to invest a lump sum amount for around three years. Being a risk-averse investor, he planned to put his money in fixed deposits. His financial planner friend, however, suggested that he should consider investing the money in fixed maturity plans (FMPs) due to the considerable tax arbitrage that they enjoy vis-a-vis fixed deposits. Owing to this, his friend said, Mishra would be able to earn much better post-tax returns from an FMP than from a fixed deposit.

A closed-end product: FMPs are closed-end debt funds that have a fixed tenure. You can invest in them only at the time of the new fund offer. “In FMPs, the intended asset allocation mentioning the rating profile of the portfolio is filed with Sebi  seven working days prior to the launch of the fund, and is also made publicly available to investors through the fund house's website,” says Amit Tripathi, CIO-fixed income investments, Reliance Mutual Fund. By looking up these details, an investor or his advisor can get an idea of the kind of return the FMP will be able to provide, and the risk it carries.

The fund manager invests the money raised from investors in a portfolio of securities. The portfolio tends to be static. The investor can exit these funds at the end of their tenure. While they are listed on the stock exchanges, liquidity tends to be low and they usually trade at a discount to their net asset values (NAV). This makes it difficult for investors to exit these funds by selling them on the exchanges.    

Lock-in gains: FMPs allow investors to lock-in the prevailing interest rates. “FMPs follow a buy and hold strategy, which helps investors lock in the prevailing yields in the market. Hence, an investor benefits more when he invests in an FMP in a high or rising interest-rate scenario, as he can capture those higher yields,” says D Jayant Kumar, head of third-party products, Karvy Stock Broking. Experts say that yields are quite attractive at present. Triple-A instruments are offering a yield of 8-8.5 per cent, double-A instruments are offering 9-10 per cent, while single-A instruments are offering 9.5 per cent onward.  

Locking yields is not possible in an open-end debt funds. “Constant inflows force the fund manager to buy new securities, while redemptions force him to sell his existing securities, due to which the yield profile of the portfolio keeps changing” says Aditya Bagree, director, Business Aggregate.     

Double-indexation benefit: Fund houses are currently launching FMPs and also advertising them heavily. The end of the financial year is a especially opportune time for investing in FMPs because of the added indexation benefit investors can get. Suppose you invest in mid-March in an FMP having a tenure of three years and 15 days. This FMP will mature in April 2022. Once the tenure of a debt fund crosses three years, the gains are treated as long-term and are taxed at 20 per cent with indexation. But there is an added benefit. “By investing for just three years and a few additional days, you can get indexation benefit for four years,” says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor. Due to this, the post-tax return from an FMP tends to be far better than from a fixed deposit, even if both offered similar pre-tax returns.

 

Avoid mark-to-market loss: When interest rates are rising, the NAVs of open-ended debt funds take a knock. Longer-duration funds are affected more than their short-duration counterparts. FMPs become attractive in such an environment also. “There may be interim volatility in these funds but there is no realised mark-to-market loss in them. Since the majority of the securities have a maturity that is similar to that of the FMP, by the time its tenure ends there is no residual mark-to-market impact,” says Tripathi. In case of open-ended funds, investors with a low risk appetite may not be able to hold on to their funds when they see their NAVs falling in a rising rate scenario. This risk does not exist in an FMP if an investor holds it till the end of its tenure.

Check portfolio for credit risk: While FMPs can help investors circumvent interest-rate risk, they are susceptible to credit risk. This is especially pertinent in the current environment, when a number of corporates are facing the risk of defaults and downgrades. “Suppose you spot a security in your portfolio which you think is of poor credit quality and could default. You may want to exit that portfolio, but you cannot in an FMP. An open-end debt fund would allow you to do so,” says Raghaw.

If you decide to invest in an FMP in the current environment, check the credit quality of the portfolio the fund manager intends to create. The portfolio should hold double-A and above rated papers. “After the recent credit related issues, fund managers are shying away from taking any risk and are mostly launching FMPs with double-A and triple-A rated portfolios,” says Abhinav Angirish, founder, InvestOnline.in. If an agent tries to sell you an FMP promising a 10.5-11 per cent kind of return, remember that such returns can only come by taking additional credit risk.

Pay heed to your liquidity needs before investing in an FMP. “If you don’t need a certain sum of money for a particular tenure, and an FMP of a similar tenure is available, you may go for it,” says Bagree.

Barring the ability to lock-in yields, open-end debt funds provide most of the other benefits that FMPs do. So, the bulk of your fixed-income portfolio should be in them, and only a limited amount of your money should be allocated to FMPs, given the difficulty the investor faces in exiting them during the tenure of the instrument. Investors who wish to take the benefit of any potential fall in interest rates (which would send NAVs rising) may also avoid FMPs.

 

Pros and cons of FMPs

Pros

• You can lock into high current yields. This benefit is not available in open-end debt funds.
• By investing for three years and a few additional days now (towards the end of the financial year), you can get the benefit of indexation over four years.
• In an open-end debt fund, an investor could panic and sell when he sees his NAV falling in a rising rate scenario. This risk is minimised in an FMP.

Cons

• These funds are susceptible to credit risk. Investors should not get lured by the promise of higher returns, since those returns can only come by taking additional credit risk.
• Liquidity is low on the exchanges. If you could need the money during the tenure of the FMP, avoid them, or else you may have to sell at a discount on the exchange.