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FMPs Stage Stunning Recovery

Investors have breathed life a new into this virtually-dead mutual fund product

The revival of fixed term mutual fund products has gathered surprising pace. From a situation where these once-dominant types of debt funds looked just about dead last year, to the beginning of a revival a few months ago, we're now in the middle of a full-fledged recovery. And with good reason - the whole saga goes to show that when a product type suits the real needs of investors, then the market will find a way of creating it. Of course, it also goes to show the crying need for an active market for corporate debt, but that's a separate story altogether.

In just about 20 days in August, offer documents for as many as 12 fixed term funds (FMPs) were filed by mutual fund companies with market regulator the Securities and Exchange Board of India (SEBI). For the post-crisis period, this is a record. Numbers aside, there is also plenty of anecdotal evidence about the expanding market for such funds. For a long time after they were introduced, fixed term funds were mostly used by large corporates to park money. As time has gone by, the product has moved lower and lower in the investor-size range. Smaller companies and high net worth individuals are beginning to use it to a greater extent. As returns from bank deposits have become more and more soft, these funds have started making sense to a larger and larger constituency of investors.

With a few caveats, FMPs make excellent (and more tax efficient) substitutes for bank deposits. FMPs are closed-end funds, so they limit liquidity. Investors can invest only during the new fund offer (NFO) period and can redeem only when the fixed-term is over. The return on them is also predictable. Before the crisis, fund companies used to offer an 'indicative' return. This has now been banned by SEBI, but investors get enough clues about exactly what to expect.

Unlike many other types of funds, FMPs' return expectations have a basis in reality. FMPs invest in debt paper with the intent of holding them to maturity. This means that regardless of any variations in interest rates and the resulting impact in the market value of the paper, the actual returns that are realised are known. That is, assuming that none of the debt becomes bad. While this is a real risk, there have been no big blow-ups. There were FMPs that had too much exposure to shaky real estate companies, but the crisis also appears to have taught investment managers the importance of constructing FMPs' investment portfolios carefully.

The bottom-line is that despite issues like liquidity, this product delivers a lot, not just to investors, but also to corporates whose paper it invests in. Since there's no real active bond market in India, all but a handful of top-tier companies need to find the actual end-investors of their debt in order to raise money. Investors too, like the lack of unknowns in their investments. In effect, fund companies have become debt-brokers through this class of product. Ideally, there should have been a highly-liquid debt market where bonds from all comers would find buyers and sellers. However many of the variables that are needed for such a bond market are missing, the most important being ratings that bond buyers can trust implicitly. In effect, FMPs have become a uniquely-suited Indian solution to this problem. They'll probably continue to serve this purpose for a long time to come.