Keep away from FMPs indicating high yields

FUND QUERIES

Every mutual fund has launched Fixed Maturity Plan (FMP) schemes. Will it be prudent to look into the quality of papers they are investing in? Also, how does one judge the credit risk before parking the money?

- Dinesh Goyal

It is always prudent to look at the portfolio of any fund before investing. But in case of FMPs, that's not possible. These are either closed-end funds or interval funds, which are rolled-over at defined periodicity. You cannot see and evaluate the portfolio of an FMP as it invests only after you have invested. So far, investors have been able to derive tax efficient predictable returns from FMPs.

 

However, in view of the interest rate rise, tighter liquidity situation and deteriorating condition of the companies in the real-estate sector, a part of an FMP portfolio of some funds can face default. This can lead to lower-than-indicative yield stated by the fund, no return or the possibility of a capital loss.

Ideally, FMPs invest in high quality instruments, which have been rated by at least one credit rating agency. In case of investment in unrated papers, prior approval of the board of directors of the AMC or the Trustee has to be obtained. But to enhance the overall yield FMPs may assume high credit risk and run the risk of default.

There are two thing investors can do to guard against such failures: keep away from FMPs indicating very high yield. Abstain from FMPs of a fund family with dominance of low rated papers in their existing FMPs.

Birla Sun Life Mutual Fund recently came out with an equity-linked FMP. Kindly tell me more about such FMPs and the risks involved in investing in such schemes.

- Ranjan Karnad

Birla Sun Life Mutual Fund is the second fund house after ICICI Prudential to come out with this new variant of FMPs: an equity-linked FMP. This product is a debt fund which intends to invest primarily in the bonds issued by the companies, banks and non-banking financial institutions.

These bonds are generally zero coupon bonds whose returns are set with the returns of the underlying assets (for instance, group of stock or index). There is no fixed coupon rate, instead a participation ratio is fixed. The return is generated on this ratio.

The participation ratio is the fixed proportion of upside in the underlying asset that the investor is entitled to get. But here's a catch, there is a cap on the upside known as knockout level. That is, if the value of the underlying asset reaches or exceeds a pre-determined level, then the investor will get a fixed rate of return.

Birla Sun Life Mutual Fund is introducing two equity-linked FMP schemes, Series-A (Aviator Plan) with maturity of 36 months and Series-B (Gladiator Plan) with maturity of 21 months. The participation ratio of Aviator & Gladiator Plans are 140-145 per cent and 97-100 per cent of the Nifty returns respectively. The knockout levels of these two plans are 190 to 200 per cent and 140 to 145 per cent respectively.

Pros and cons of this fund: This product is suitable for risk-averse investors who would like to participate in the market upside and not in the downside. That is, if the underlying asset does not go up as expected, the investors would at least get their initial capital back.

Thus the only risk is that there will be no capital appreciation. On the downside, unlike conventional FMPs these types of schemes have an entry load or exit load. Entry loads on the Aviator and Gladiator Plans are 2.25 per cent and 1.50 per cent respectively.

An exit load of 2 per cent will be borne by the investors if redemption takes place within one year and 1 per cent if money is redeemed after 1 year but before the maturity date. ICICI Prudential AMC's Equity Linked FMP does not have any entry load, but has higher than average exit load of 5 per cent for redemption before maturity.

I have invested in one of the 366 days FMP Plans. What would be my tax liability for this investment? I have come to know that the income from a MF is not taxable for individuals. Hence I invested in an FMP rather than a bank FD. I have opted for the growth option.

- Amit Shah

Your understanding is incorrect. All kind of income from a mutual fund is taxable. Only long-term capital gains on equity oriented funds are not taxed. Income from both, debt funds and FMPs, are taxable though their tax incidence is not the same. You are liable to pay tax on capital gain from investments in FMPs.

Since it is a 366 days FMP, long-term capital gain tax will be charged at the rate of 10 per cent without indexation or 20 per cent with indexation, whichever will be lower. The indexation benefit makes FMPs an attractive investment avenue compared to fixed deposits. Since you have taken the growth option, no dividend distribution tax (DDT) will be imposed.

Recently, the company fixed deposits (FD) bought for my son have matured. He is in class 11 right now. I will need these funds by mid-2010. Where should I invest the proceeds?

- AC Shah

Usually, the rate of interest given by the companies is around one to two per cent more than bank fixed deposits. But a company FD is not risk-free and carries a high risk of default. You can invest in FMPs, which are more like an FD, but are more tax-efficient. Debt funds with low average maturity could also be considered as they carry lesser interest rate risk. Proven funds like Kotak Flexi Debt or Birla Sun Life Dynamic Bond Retail fund can also be a good investment proposition.