Want Risk-free Fixed Returns-are Fmp’s the Answer?
Tuesday, July 20th, 2010
Want risk-free fixed returns-Are FMP’s the answer?
Introduction
Fixed Maturity Plans (FMPs) have significantly gained popularity as interest rates in India have increased and equity market returns diminished substantially.
To define, “A fixed Maturity Plan is a closed-end fund that invests in debt and money market instruments of the same maturity as the stated maturity of the plan. The focus of a fixed maturity plan is to provide a stream of income through interest payments, while exposing the investor to a lower level of risk.”(Investorwords.com)
An FMP is an investment avenue that yields reasonable return with minimum risk, adequate liquidity and tax efficiency and has gained popularity with investors waiting for the markets to become stable again.
Features
Ø Composition: FMPs generally invest in fixed income instruments i.e. government securities, Commercial Paper (CP), Certificate of Deposit (CD), bonds, money market instruments etc. So they are among less risky investment options, considering highs and lows of share market. These are closed-ended funds, meaning that one can only enter them when they are launched and exit them when their term is over. One can also exit them earlier generally after paying a load that is very high
Ø Predictable return: Fund companies offer an ‘indicative return’ for FMPs. FMPs invest in debt instruments with the intent of holding them to maturity. This means that regardless of any ups and downs in the market value of the investments, the final earnings are predictable. Therefore, the indicative returns that FMPs provide to investors reflect the reality
Ø Tax efficiency: If one is looking at a fixed income product FMP’s score over FD’s in terms of tax efficiency, especially for people falling under the highest tax bracket. When you put money in a fixed deposit, the interest gets added to your income. In FMPs longer than a year, if you wish to take all your gains as capital appreciation, the taxation is merely 10 per cent without indexation benefit or 20 per cent with indexation. Even for investments less than a year, there’s a tax advantage if the investor takes the option of receiving the gains in the form of dividends. In this case, individual investors will get taxed at 12.5 per cent of the returns and corporate will get taxed at 20 per cent
*Indexation is a technique to adjust income payments by means of a price index, in order to maintain the purchasing power of the public after inflation.
Ø Double Indexation Benefit: For calculating capital gains, we reduce the cost from the sale value. For calculating long-term capital gains, such cost can be enhanced by the inflation multiple. For this purpose, government releases the index figures for each financial year. Such an index is known as the Cost Inflation Index (CII).With the increased cost after the effect of inflation , the capital gain figure is reduced and therefore the tax on gains is reduced .Also, one can have double indexation benefit by keeping the investment for little more than one year . For example, the date of entry is 27th march 2007 i.e. FY- 06-07 and date of sale is 4th of april2008 i.e. FY 2008- 09.thus by keeping the investment for a small period of the next financial year , an investor can use the facility of the CII for two years
Ø Credit Rating and Safety. FMPs have been predictable and safe. FMPs invest in high quality instruments, which have been rated. In case of investment in unrated papers, prior approval of the board of directors of the AMC or the Trustee has to be obtained. They invest in debt having different levels of risk but they usually stick to relatively low-risk debt issues. However, to enhance the overall yield FMPs may assume high credit risk and run the risk of default. As the liquidity and credit conditions are tightening, some of the companies in which FMP’s have invested could be relatively unsafe. In case of such an investment the actual return will be lower than the predictive return, also there are chances of a capital loss.
Ø Lower cost: FMPs involve minimum expenditure on fund management, as there is no requirement for rebalancing of portfolio according to the market conditions. Since these instruments are held till maturity, there is a cost saving in respect of buying and selling of instruments
Ø Dual benefit of equity linked FMP: This is structured in a way that you get some share if markets perform very well and also your capital remains reasonably protected. You get the benefit of both the worlds as these have both debt and equity in their fund composition. Generally the ratio tends to be 70-80% in debt and 20-30% in equity. FMPs having equity exposure are structured in such a way so that investors’ capital remains protected.
Is FMP investment risky?
Ø Default Risk: FMPs are not totally risk-free options as they appear to be. This is because they invest in commercial papers issued by companies, which is an unsecured debt. In bad times, some companies, with whom the asset management company places the funds, could default on their commitments. This could put the principal amount at risk
Ø Exposure to volatile sectors: Fixed maturity plans (FMPs) do not disclose their asset portfolios to their investors, unlike other mutual funds such as equity funds. Because of this the fund manager sometimes invests in risky sectors. (According to SEBI, there is significant exposure of FMPs to “volatile” sectors such as realty and NBFCs)
Ø Mismatch in the portfolios: In order to attract investors, fund houses promise returns superior to those offered by other funds for fixed income products To deliver these returns, fund houses would invest the money in those debt securities that have a maturity period longer than that of the scheme as these give higher returns . For example, one-year FMP scheme would invest in debt securities with a maturity period of 18 months. But a few days from the expiry of the first FMP, the fund house would launch a second FMP. At the time of repayment, the older investor would be paid by the money received from the investors in the new scheme.
Starting October 2008 , for reasons like tight liquidity conditions and concerns about the quality of the debt instruments held by these FMP ‘s , many institutional investors started pulling out their funds .As a result of this, the fund houses came under pressure of increasing large volume redemptions
It was this practice that the market regulator Securities and Exchange Board of India (SEBI) wanted to put an end to, when it revised rules to ensure that close-ended schemes cannot have assets with a maturity beyond that of the scheme
SEBI’s recent measures:
To solve this crisis (SEBI) is drawing plans to make early withdrawals from Fixed Maturity Plans (FMP) difficult by blocking this route in case of close ended schemes. Earlier there was a liquidity provision with direct redemption of closed ended funds instead of listing them. Now, SEBI has forbidden this ‘early redemption’ route making listing compulsory for close ended schemes of mutual funds, and disallowing early exit from these schemes.
For investors who want liquidity before maturity there is an option for sale in the secondary market.
SEBI also revised rules to ensure that the predicted and the initial portfolios are similar; it suggested that close-ended scheme cannot have assets with a maturity beyond that of the scheme. Fund managers will have to structure their portfolio by buying assets that will mature as per the tenure of the scheme, i.e debt investments must be made only in those fixed instruments whose maturity date is not beyond the funds’ own redemption date.
Is FMP the right choice in this volatile market environment?
In this volatile phase of the stock market, one would like to stay liquid so that he can buy as and when a suitable opportunity arises. One may not like to lock in his funds in order to take advantage of a buying opportunity. Or perhaps, one is a risk-averse investor who expects a reasonable return through fixed income investment. Or one has excess funds that are required at a later stage but are looking to temporarily park it somewhere safe and gainful. Recently there has been heightened apprehension about the quality of the FMPs’ investments and reports of investors seeking premature redemptions even by paying substantial exit loads
But investing is all about diversification in various asset classes and FMP’s is one of the means for the same with stable returns and security vis-à-vis equity investments.
Jasjit Bhatia
http://www.articlesbase.com/investing-articles/want-riskfree-fixed-returnsare-fmps-the-answer-694238.html
