FundsIndia Strategies: What FMPs To Go For

It’s that time of the year when the word ‘double indexation tax benefit’ is often heard in the investment world. And the term double indexation is often used in the context of Fixed Maturity Plans (FMPs). But that is not the primary reason for us to review this class of close-ended mutual funds this week.

We are recommending select (please note that not all FMPs carry the same risk and return opportunity) FMPs at this juncture for 2 reasons: One, FMPs are best locked into when rates are at a high. While we are not claiming that rates will fall from here soon, it does appear that rates are at their multiple-year highs, with bond/gilt rates showing little signs of going up further; thus providing a good opportunity to lock yourself in to high rates.

Closer to the end of the year, high liquidity requirements also mean that a number of instruments with good yields would be available in the debt market. Two, as AMCs tend to float more FMPs during the end of a financial year for investors to gain from capital gains indexation, we have more options to choose from in the FMP world.

FMPs are close-ended debt schemes with a fixed maturity horizon. That means they are open for investment for a few days during the launch, and are then closed until maturity, which may be just a month away, or as long as five years away. FMPs invest in money market instruments, bonds and government securities. Their fixed tenure often makes them comparable with fixed deposits.

Lower Rate Risk

However, unlike fixed deposits, FMPs do not guarantee returns. Still, they are considered low risk, especially when compared with open-ended debt funds, for a few reasons. First, FMPs choose instruments in such a way that the tenure of the underlying investment coincides with that of the FMP. For instance, a 1-year FMP will invest in debt instruments that also have the same maturity.

By doing so, the fund will ensure that it gets the interest income (called accrual) on these instruments when the FMP matures. This strategy ensures that returns are positive if held to maturity, unlike open-ended funds that may slip into negative returns once a while.

Two, as FMPs are locked in (although they have an exit option through the stock exchange route, they are thinly traded and hence not liquid), it does not face the pressure of redemption and hence, it does not have to churn its portfolio to meet exits. This also provides stability to FMPs.

Tax Efficient

On the return front too, FMPs held for over one year can deliver superior post-tax returns when compared with fixed deposits as a result of the indexation benefit. Unlike fixed deposits, FMPs (and all debt funds) enjoy capital gain indexation benefit if held for more than a year. Interest on fixed deposits, on the other hand, will be taxed at your regular income slab rate.

Although  dividends are taxed at the fund’s end at 28.3% (as dividend distribution tax), the growth option in an FMP provides leeway to index cost and sometimes enjoy nil capital gains tax in periods of high inflation (as the indexation will be done in line with inflation).

The way FMPs are structured also makes the indexation benefit more attractive. Often times during the end of a financial year, the tenure of an FMP would be a year and a few days or 2-3 years and a few days. For example, an FMP launched in end-March 2014 for 380 days will mature in April 2015. But for indexation, the investment will be considered to be made for 2 years – that is from FY 2013-14 to FY 2014-14, thus providing higher indexation of cost.

You may note that FMPs of less than one year will be taxed at your income tax rate. Hence, if you are in the high tax bracket, short-term FMPs may not make for great post-tax products for you.

What FMPs We Recommend

Since, the very idea of going for a close-ended product such as FMP is to keep your interest rate risks at bay, we prefer to keep the overall risk reduced by going for those instruments that provide adequate returns with least risk.

As the portfolio of FMPs would not be known until the money is invested, we would like to go by the scheme information document’s disclosure on the credit rating of the instruments in which the scheme seeks to invest, as well as the track record of the fund house in managing debt money.

We are comfortable restricting to those funds that take exposure to certificates of deposits (which have current yields at over 9.6% for 1 year), A1+ commercial papers (with yields at over 10% for 1 year), as well AAA-rated debenture with 1 year maturity. Those with limited exposure to AA rated were also considered to pep returns, provided the rest of the portfolio is in high-rated instruments.

We also stuck to shorter tenure as the instruments with longer tenure may have more uncertainty in terms of credit worthiness.  We also looked at the other criteria used by the fund in choosing its universe and what are the segments that the scheme will avoid investing, to assess the possible risks.

We also chose those funds that would be available for investment at least until next week (given the short tenure for which these funds are open).

Based on this, we have the following funds for now:

We are regulating filtering our list of FMPs based on their tenure and investment universe. If you need regular updates on upcoming FMPs that will be investment worthy, make an advisor appointment online using your FundsIndia account and our advisors will get in touch with you.