What a fund house must do when its FMP goes bust: Pay out what it has

This is preferable to rolling over the FMP, say experts

Two fund houses recently informed their investors in fixed maturity plans (FMPs) that they would not be able to pay them the entire redemption amount. These fund houses were facing delays in being repaid the money invested in debt papers of Essel group companies. All lenders to this group have agreed not to sell the equities held as security, and have instead decided to wait for these companies to pay up their dues by September. What is interesting is that the two fund houses took divergent approaches when faced with the inability to pay. Understanding the pros and cons of the two approaches will enable investors to make more informed decisions when faced with similar situations in the future.

One fund house—let us call it A—chose to pay up its investors whatever money it had received. It informed them that it would pay up the balance when it receives the money due from its borrowers. The second fund house—let us call it B—chose to roll over, or extend the tenure, of the FMP by a year.  

Immediate payout is better: While opinion is divided on which of these two approaches is better, more experts felt that distributing whatever money the fund house has in its hands is the right thing to do. “When people invest in an FMP, they plan for a certain need. With this approach, they at least get some part of their expected return back, and can now wait for the balance interest portion,” says the chief executive officer (CEO) of a fund house who did not wish to be identified. Vidya Bala, head of research, Fundsindia.com, too, regards the approach of paying out upfront as the right one. “This is the more transparent thing to do,” she says.     

When the pay-out is made right away, the gains get taxed according to existing norms. “Many people invest in FMPs for double-indexation benefit. It is possible that the tax rules could change in a year’s time, in which case the investor’s gains could be treated differently,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.  

The upfront pay-out model, however, has a small downside. “Investors may get the money due to them in small tranches. Since the amount is not meaningfully large, there is a chance that it could get spent and may not be reinvested or used for a meaningful purpose,” says Dhawan. 

Some experts hold a different view. “Optically, at least, the rollover approach gives greater comfort to investors. Here, the fund house is conveying to its investors that the money will come, even if it comes a year later,” says Nikhil Banerjee, co-founder, Mintwalk. 

Customers of both the fund houses face the risk that the borrowers may not pay up their dues, in which case they would suffer losses. However, those who agreed to the rollover could suffer more. If they suffer a loss even after waiting for a year, they would have lost both money and time. 

Communication should be transparent: One issue with Fund House B’s approach was in the way the matter was communicated to investors. The fund house did not say that the FMP was being rolled over due to difficulties in repayment by borrowers. Its communique claimed that the rollover was happening because “the yields prevailing in the short-maturity bucket present an option for investors to lock in their investments at current prevailing yields”. Experts say that this amounts to lack of proper disclosure. 

In deciding to roll over, Fund House B went by the feedback of its distributors, who in turn consulted investors. Most investors agreed to a rollover. Those who wanted to exit were given the option to do so. 

Should fund houses bear the loss? The third course available to the two fund houses was to take the losses on their books. In the past, some AMCs have bought downgraded securities from their own debt schemes and transferred them to their own books, one example being Franklin Templeton Asset Management (India), which had bought JSPL debt papers. Some experts are of the view that doing so would help restore confidence.

Increasingly, however, this is not being viewed as a viable option, one reason being the large amount involved. “Given the ongoing liquidity and NBFC crisis, fund houses are not sure if the situation will worsen, so they don't want to take an additional burden on themselves,” says Banerjee. 

Another argument is that doing so would be against the nature of the vehicle. “Mutual funds are pass-through vehicles. If they start taking losses on their own books, they would have to make provisions for such losses, and then the capital required for setting up an AMC would rise to a much higher level,” says Dhawan. Besides, he says, fund houses don’t bear the loss when there is one in equity funds, so debt funds should not be treated any differently. 

What should you do? While recent events have shaken investor confidence in debt funds, investors should not give up on them altogether. “These are tax-efficient products that can give you better returns on a post-tax basis than fixed deposits,” says Radhika Gupta, chief executive officer, Edelweiss Asset Management. 

Investors should only opt for FMPs when interest rates are high and they want to lock into them, and not for double-indexation benefit, as this can be availed through an open-end fund also. The latter allows the investor to examine the portfolio at the time of entry. Moreover, if he gets to know about the existence of poor-quality papers in his fund, he can exit it before a downgrade happens. Exit is available at a high cost in an FMP, as selling on the stock exchange usually happens at a steep discount to the net asset value. In the current stressed environment, if at all you invest in an FMP, stick to those that will invest in the highest-grade papers. Finally, avoid debt funds with high concentration to a company or group and stick largely to shorter-duration funds.   

Tips for debt fund investors

• Stick to open-end funds as you can see their portfolios before investing in them

• You can also exit these funds if you learn that there are papers that could potentially default

• Invest in FMPs only to lock in high interest rates. In that case, stick to those that promise to create the highest grade portfolios

• When selecting a debt fund, ensure that it is well diversified and concentration in a particular company or group’s paper is not high

• Do not go just by the yield-to-maturity. Pay heed to portfolio quality as well

• Currently, invest 80 per cent or so of your debt portfolio in shorter-duration funds that avoid both credit and duration risk