InvestorQ : What is your opinion on investing money in fixed maturity plans (FMPs) of mutual funds? Is it a good idea or should I be careful after the recent episodes?
Moii Chavate made post

What is your opinion on investing money in fixed maturity plans (FMPs) of mutual funds? Is it a good idea or should I be careful after the recent episodes?

Sam Eswaran answered.
8 months ago

Open any mutual fund website or the MF NAV page of the newspaper and you are likely to be accosted by a product called fixed maturity plans (FMPs). What exactly are these plans and how do they fit into your investment scheme of things. A Fixed Maturity Plan (FMP) is a closed-ended fund that invests predominantly in debt instruments. That is the where the key advantage of an FMP comes in. Since it is a closed ended fund, it can invest in instruments whose unexpired maturity precisely matches with the tenure of the FMP.

For example, a 3 year FMP will invest in debt with an outstanding term to maturity of 3 years. So the yield is not only indicative but to an extent it becomes like an assured return product. It is also free of any interest rate risk since it is locked in till the date of maturity. This helps eliminate the interest rate risk or the risk of price depreciation almost entirely. Such products can have a lot of value in the current scenario when the RBI has already hiked rates by 50 basis points and looks all set to go for a few more rate hikes.

Do FMPs really score as an investment and financial planning product?

Here are a few important takeaways for you on FMPs.

· FMPs offer the safety and security of debt instruments. Debt securities are, anyways, much safer and more stable compared to equities. Most FMPs invest in highly rated instruments like government bonds, institutional debt; “AAA” rated debt etc so that the default risk aspect is almost eliminated. With low default risk and limited price risk, the FMPs almost work like an assured return product for investors.

· Since FMPs are closed ended funds, there is no scope for any price risk as funds are locked in. Hence any rise in interest rates does not have any negative impact on the NAV of the fund. This is specifically useful for institutional investors who need to provide MTM losses in their books. Since FMPs are closed ended they are locked into fixed returns and hence there is no interest rate risk in FMPs. As a result they are the ideal product in a rising interest rate scenario.

· Compared to the traditional bank FD, FMPs are more tax efficient. When you invest in bank FDs, the interest earned is taxed at your peak rate of tax. So if your tax rate applicable is 30% then the tax on your FD interest is 31.2% (including cess). In case of FMPs always opt for the growth plan. The dividend plan may not be too efficient as the dividend distribution tax (DDT) is around 29.12% including the surcharge and cess and is almost as high as the bank FDs. Hence you should ideally prefer a growth plan.

· When it comes to FMPs, the tenure matters a lot. If the tenure of the FMP is up to 3 years, it is treated as STCG. That means, the capital gains will be taxed at your peak rate of 31.2% and hence there is no special advantage in the FMP, except that returns are higher than in case of bank FDs. However, if the FM is held for more than 3 years, then it becomes LTCG and will be taxed at a concessional tax rate of 20% along with the benefit of indexation. Indexation is the benefit that the tax department gives you to compensate for asset inflation over the years. If you bought an asset at half the price 10 years back then it is unfair to charge you the full capital gain. Let us look at indexation and the dual indexation benefit of FMPs in greater detail.

How FMPs help in realizing the unique benefits of double indexation?

Let us look at double indexation benefit on FMPs with an example. Assume you purchase an FMP at the end of the fiscal year and then sell it after holding it for a little over 3 years at the beginning of the fourth fiscal. Your holding period is just a little over 3 years but the benefit of indexation you get is increased by 1 year. How is that? Let us see how the benefit of double indexation works in practice. Many fund houses issue their FMPs around the end of a fiscal for a period of 1100 days and redeem their FMPs at the beginning of the fourth fiscal year to maximize the double indexation benefits. If you buy an FMP at the right time ahead of the end of the fiscal, you can actually realize the advantage of higher risk-adjusted returns on these FMPs.