Bank term deposits or fixed deposits (FDs) are default investment choices for most retail investors in our country. They assure safety of invested amount and fixed rate of return. However, if investors are ready to forgo the comfort associated with assured returns, then mutual fund Fixed Maturity Plans (FMPs) can be excellent alternatives to FDs. In this blog post, we will discuss about FMPs, their advantages and disadvantages versus other fixed income schemes, and how investors can select the right FMPs for investments.
What are Fixed Maturity Plans or FMPs?
Fixed maturity plans are close ended debt mutual fund schemes which invest in different debt securities like commercial papers, certificates of deposits, bonds etc. Since FMPs are close ended schemes, they can be bought only during the new fund offer period (NFO). Once an FMP is closed for subscription, you can buy them only in stock exchanges (provided you have demat and trading accounts) but the liquidity of FMPs in stock exchanges is quite low. Therefore, the offer period is the only opportunity to invest in FMPs. As the name suggests, these are fixed term schemes and you cannot redeem them, partially or fully before maturity. If you have a demat account, you can try to sell the FMPs in the stock exchanges but as stated earlier, the liquidity in the exchanges is quite low. Therefore for all practical purposes, investors will have to wait till maturity to get liquidity.
Advantages of Fixed Maturity Plans or FMPs
- Fixed Maturity Plans or FMPs invest in debt securities whose maturities match with maturity of the scheme. These securities are held till maturity and therefore, there is no interest rate risk. Risk in FMPs is much lower than open ended schemes, whose prices (NAVs) fluctuate with interest rate changes. Even if the fund manager of an open ended debt fund intends to hold securities in his / her portfolio till maturity (accrual strategy), he / she has no control over redemptions. This will affect the scheme NAVs. Let us explain with the help of an example. Imagine a scenario where yields are rising and prices are falling. If there are redemptions, then the fund managers of open ended debt funds will be forced to sell securities of lower durations to reduce losses; the duration profile of the scheme will change towards higher durations and this will affect returns of investors who remain invested, if yields rise further – returns will fall. FMPs, being close ended schemes, will not face scenario of early redemptions and therefore, FMPs have much lower interest rate risk.
- In a scenario where yields are falling, open ended mutual funds will have to replace maturing debt securities with lower yielding securities – this will lower portfolio yields. Yield changes are inversely related to price changes; lower yields will increase the price and investor returns will be good. But if the yield trajectory gets inverted, then open ended debt fund investors will have lower yielding securities in their portfolio and simultaneous price decline which will make their investment more volatile. Since the maturities of underlying securities in an FMP’s portfolio matches with the scheme maturity, there is no reinvestment risk / volatility.
- FMPs have lower expense ratios compared to open ended debt mutual fund schemes.
- FMP returns are much more predictable than open ended debt funds. Even though unlike FDs, FMPs do give assured return, knowledgeable investors can get a fairly good sense of returns by going through the scheme information document (SID). SID of FMPs provides investors overview of indicative allocations to various types of securities and expected yields (which are based on current yields). Since securities will be held till maturity, the average yield to maturity of securities in an FMP portfolio, adjusted for expenses, should be indicative of returns which investors can earn in these schemes.
- If FMP tenures are of more than 3 years, then investors will enjoy long term capital gains taxation on returns from FMPs. Long term capital gains of debt mutual funds are taxed at 20% after allowing for indexation benefits. FD interest, on the other hand, is taxed as per the income tax slab of the investor. We will discuss the tax implications in more details later in this post.
Disadvantages of FMPs
- FMPs have lower liquidity compared to open ended debt mutual funds and even FDs. You can redeem units of open ended debt funds anytime after the exit load period without penalty or during the exit load period by paying the load. FDs allow premature withdrawals even though they will deduct a penalty from interest. Premature withdrawals are not allowed in FMPs.
- The lower risk which FMPs enjoy over debt funds also prevents FMP investors from taking advantage of price appreciation from interest rate declines which open ended debt fund investors can enjoy.
- When yields are low and falling, FMP returns will be lower due to low yields, whereas open ended funds may invest in longer duration securities which have higher yields. You should have very clear goals when investing in FMPs.
Tax benefit of Fixed Maturity Plans or FMPs versus FDs
As stated earlier, Fixed Maturity Plans or FMPs with tenures of 3 years or longer enjoy considerable tax advantage over FDs. For the benefit of investors, we will illustrate this with the help of an example. Venkat and Srinivas are two investors, both in the 30% tax slab. Venkat invested Rs 1 Lakh in a 3 year FD, while Srinivas invested the same amount (Rs 1 Lakh) in 3 year fixed tenure FMP. Let us assume both the FD and FMP gave 8% annually compounded interest / return. Let us see the tax implications of Venkat’s and Sriniva’s investments.
You can see that, for the same pre-tax return FMPs (over 3 year tenures) enjoy a significant tax advantage. There is no TDS in FMPs, whereas banks will deduct TDS for your FD interest every year. Further, irrespective of TDS deducted by the bank, investors will have to declare FD interest as income in their income tax returns and pay tax accordingly. Incidence of tax in FMP arises only on maturity, when FMP investment will enjoy debt fund long term capital gains taxation for tenors over 3 years.
Points to consider when investing in FMPs
AMCs offer FMPs to investors from time to time. Advisorkhoj brings new FMP offers to investors’ notice regularly through our portal and newsletters. AMFI also has details of all FMP offers on their website. At any point of time, there may be multiple FMP offers available to investors. Investors should consider the following points, when selecting FMPs for investments.
- The most basic point to consider in FMPs is your investment tenor. Since FMPs are close ended schemes, you should factor in liquidity considerations when investing in FMP.
- The next most important consideration should be credit risk of the FMP scheme.Offer document or SID will have information on the credit quality of the indicative portfolio. Securities with lower credit quality will give higher yields but there is also higher risk of default. Not all lower quality papers will default, but in our view, average retail investors should invest in FMPs which invest in highest quality (AAA, AA, A1+ etc) papers. As a rule, when investing in debt funds, you should always ensure that you are comfortable with the credit risk because it is the most unpredictable risk and can hurt investors the most.
- Once you are comfortable with credit quality, you can make informed FMP investment decisions by estimating expected returns from indicative portfolio and expected yields (details can be found in the offer document). We will discuss with the help of an illustration, how to estimate expected FMP returns from the offer document.
Indicative portfolio (please see the offer document), figures are illustrative
Now you will have to make some intelligent or informed assumptions. Let us assume the fund manager invests 95% in AA NCDs and the balance in CPs, CDs, G-Secs and T-Bills. An FMP’s offer document also provides expected yields of different securities. For example, this offer document shows that the expected yield of AAA NCDs is 8.6%. You can add another 30 bps of yields for AA and estimate weighted returns: 8.9% X 95% = 8.5%. Similarly, you can estimate weighted returns for other types of securities and estimate the portfolio / scheme returns. Then you should make adjustments for expenses and estimate net returns. You should evaluate multiple FMPs on offer and make an informed choice based on expected yields and credit quality.
In this blog post, we discussed about Fixed Maturity Plans or FMPs. FMPs are great fixed income investment options in a high yield environment because by investing in FMPs, you can lock in high yields with no volatility / interest rate risk. While yields have come down from their peak, yields are still quite high at around 7.3%, though on a declining trend with expected cuts in interest rates by the RBI / pause on rate hikes by the Fed. With uncertainty about the rupee exchange rate and other risk factors, FMPs are good fixed income investment options to lock in these yields for 3 years. However, you should ensure that you are comfortable with the credit quality profile of the FMP. You should consult with your financial advisor if FMPs are suitable for your investment needs.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.