The Nitty-gritties Of FMP's

Fixed Maturity Plans (or FMP's, as they are popularly abbreviated) are a category of close ended debt funds. What this essentially means is that these funds invest in bonds and related instruments, and that one can only invest into them during the NFO or New Fund Offer. FMP's have lock in periods that usually range from 3 months to 3 years, and they do not have an exit window or option (barring selling your units on an exchange) - so be doubly sure before you invest.

Touted as a superior alternative to Fixed Deposits till a few years ago, FMP's have witnessed their popularity waning over time. Are FMP's a good option for you?

Let's find out.

Where they invest
FMP's invest in a mix of fixed income instruments including T-Bills, Certificates of Deposit, NCD's and government securities. One of the main objectives of the Fund Manager would be to match the duration of the bonds with the duration of the FMP. Intuitively, it follows that an FMP cannot hold a bond that has a higher maturity period than the duration of the scheme. For instance, a 3 month FMP will exclusively invest its money into 3 month commercial papers with a high to moderate credit rating. The Fund Manager will also aim to play a balancing act between risk and returns, by investing in a diversified portfolio of bonds and not restricting the portfolio to AAA rated bonds alone. On the other hand, investing too high a percentage into lower rating bonds creates a high degree of credit risk within the portfolio, which is undesirable.

Rajiv Shastri, MD & CEO, Peerless Funds Management, believes that one's decision to invest in FMP's has more to do with investors' goals and the suitability of FMPs to those, rather than the environment. "Investors seeking to invest in FDs need to consider FMPs as a viable alternative, one that may reduce risk through diversification while providing competitive post - tax returns", Shastri says.

How much return can you expect?
A few years back, fund houses were permitted to disclose 'indicative yields' on their FMP portfolios, although these returns were not guaranteed. Subsequently, the Securities & Exchange Board of India banned the disclosure of indicative yields in 2009. In 2011, however, SEBI permitted fund houses to disclose the broad categories of fixed income securities that their FMP portfolios could comprise of.

By observing the broad split of fixed income securities that an FMP intends to invest into, it is possible to arrive at a rough estimate of expected returns - although this may prove to be too tedious for a layperson. Shastri offers a shortcut to estimate FMP returns. "Unfortunately, information on market yields is not easily available to investors. However, investors may look up the Govt. Security Yield for the relevant period (3 year Govt Security yield for a 3 year FMP) as a reference point. Since FMPs typically invest in non - government debt instruments, the available yield should be higher than this reference point. The difference between the two should also help investors ascertain the credit risk in the FMP. Typically, the larger the difference the higher the credit risk", he advises.

Let's take the example of HDFC Fixed Maturity Plans - Series 36 (a 3 year FMP), which has indicated that it plans to invest 75-80 per cent of its portfolio into AAA rated NCD's and 20-25 per cent into AA rated NCD's. A quick check will tell us that the yields on AAA rated NCD's are in the range of 8-8.5 per cent and AA rated NCD's in the range of 9-9.5 per cent as on date. A back of the envelope weighted average calculation gives us a rough estimate of an 8.5 per cent annualized return.

However, one also needs to factor in the 'expense ratio' of the scheme (the cost borne by the AMC to launch, distribute and manage the fund) and deduct it from the return estimate. Typically, FMP's have low expense ratios, in the range of 0.5 per cent per annum or so. Assuming this figure, we can deduct it from the expected yield of the bonds to arrive at a ballpark 8 per cent annualized return estimate for this particular FMP.

Taxation
FMP's, being a type of debt fund, are taxed accordingly. Returns from FMP's that mature in less than three years will attract short term capital gains taxes, and the gains will be clubbed with your regular income and taxed at the margin. Long term capital gains will be indexed (based on the change in the cost inflation index between the year of purchase and the year of maturity) and taxed at 20 per cent.

Do they really score over FD's?
Until 2014, long term capital gains taxes on FMP returns applied after a short holding period of one year. This made them a more tax efficient alternative to FD's even in the short run, and made the 'non-guaranteed' return worthwhile. However, in the 2014 union budget, the government changed the minimum timeframe for claiming long term capital gains taxes on debt funds to three years. This essentially acted as a dampener for FMP investors, as post tax FD and FMP returns were essentially brought at par in the short term, with the latter having no guarantees or assurances either.

That said; FMP's still score over Fixed Deposits, if you have a low risk appetite a time horizon exceeding three years. "FMPs offer 2 distinct advantages over FDs. Firstly, it is possible to achieve risk diversification with just one investment transaction since an FMP portfolio consists of instruments from various issuers. Secondly, if an FMP is held for more than 3 years, then the gains from it are treated as capital gains and attract a lower tax", says Shastri of Peerless Funds Management.

Let's take an example. The Cost Inflation Index (CII) has risen by 26% in the past 3 Financial Years from 852 to 1081. Let's assume that inflation reduces, and the CII subsequently grows at a slower pace in the next three years, say by 20 per cent.

Going back to our previous example of HDFC Fixed Maturity Plans - Series 36, which we estimated would yield an 8 per cent CAGR for 3 years; Rs. 100 invested in this scheme would likely mature at Rs. 126 or so in 2019. The tax implication in this case would be 20 per cent of the indexed profit of Rs. 6, giving us a post-tax profit figure of approximately Rs. 24.80. This is approximately Rs 5 (5 per cent) higher than the post-tax profit on a Fixed Deposit of the same maturity - which offers a higher assured return of 8.75 per cent (assuming the highest income tax bracket).

In conclusion, one could say that FMP's may be considered as part of a well thought out asset allocation strategy. It's a low risk investment that offers affordable diversification across multiple fixed income securities. Make sure you opt for the 3 year plus variety, which offers increased tax efficiency though.