Rising rate scenario favors FMPs

With the interest rates going up across instruments, Fixed Maturity Plans (FMPs) gain investor interest. For those not looking for fixed returns, FMPs can deliver superior returns to bank fixed deposits, especially in a rising rate scenario. In this article, we will discuss what FMPs are and how they can help you make the best of this rising rate scenario.

What are FMPs?

Fixed Maturity Plans are close-ended debt funds which invest in debt instruments such as commercial papers, certificate of deposits, corporate bonds and government securities, that match the maturity of the fund. This means, a 3-year FMP will invest in instruments that mature in 3 years. Like all close-ended funds, FMPs will only be open for a few days (during the issue period). The maturity amount will be credited to your bank account once matured. It cannot be withdrawn before maturity, as is the case with all closed-ended funds (unless you find buyers in the stock exchange). Even though close-ended funds have to be mandatorily listed on the exchange, liquidity remains low as trading hardly takes place in these funds.

Since FMPs are close-ended, inflows and redemptions are restricted. It essentially means that the fund is pooling money and investing in a bunch of instruments on your behalf that mature in the same period. During high interest rate periods, this would be advantageous as your fund would have locked into high interest instruments. Unlike open-ended funds, which can face redemption, these funds do not have to sub-optimally sell instruments since money cannot be redeemed until maturity. To this extent, the underlying yield of the portfolio is typically the returns of the portfolio.

FMPs come with different maturities from a few months to a few years. But the ones with three years and above are more advantageous because of tax treatment of debt funds. Capital gains on debt funds are taxed at 20% with indexation for over three years. For a period below three years, they are taxed at income tax slab rate.

For example, if you had invested Rs. 50,000 in a three year FMP – Aditya Birla Sun Life Fixed Term Plan – Series MQ, which launched on 11 June 2015, you would have got Rs.63,406. The fund returned 8.24% during the period. Since the holding period is more than three years, taxable gains after indexation will only be Rs.8288 instead of Rs.13,406. Therefore, the tax outgo at 20% will be Rs.1657. Had you invested in a three year FD during the same period, you would have got Rs.62,485. The prevailing rate at that time was 7.5%. At 30% tax bracket, your tax outgo would be Rs.3746 leaving you with much lower post-tax gains.

Why is this a favorable time to look at FMPs?

When coupon rates offered across instruments are looking attractive, FMPs let you access these high interest instruments. For example, there are a number of bonds and debentures coming out with offers with higher interest. Through an FMP you can own a diversified portfolio of such bonds.

5 year corporate bonds are trading at around 8.8% as on June 2018 against 7.3% in Feb 2017, more than a year ago. With yields looking attractive, FMPs provide a good opportunity to lock into high interest rates. It provides a good alternative to Fixed Deposits, if you are looking at a low-risk investment for a short period.

Risk in FMPS

But it is also important to assess the risk-level of FMPs as they will invest across diverse instruments. The scheme information document of NFO will specify where the fund will invest. If it invests it majorly in government securities or high rated papers such as AAA and AA, it will be a moderate risk fund. Anything below that will require higher risk appetite. Keeping that in mind, FMPs have the potential to generate better returns at this juncture if you align your goal to maturity of the fund.