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Back In Vogue

FMPs are starting to attract investors again, but there are a few things to keep in mind before investing in them…

Way back in March 2007, Fixed Maturity Plans (FMPs) peaked in popularity, accounting for 50 per cent of the assets of debt mutual funds. So by comparison, to say that they account for 31 per cent of the assets four years later (June 2011) seems to state that they have dropped in the popularity contest. In reality, they are back in vogue. In the last two months of 2009, FMPs were so shunned that they accounted for slightly less than 4 per cent of the assets of the debt schemes. From that low, they have risen substantially.

The rise in popularity is simply because the interest rate scenario is conducive to such an investment. Since April 2010, the Reserve Bank of India has been the most aggressive central bank in Asia and has increased its rates on 10 separate occasions in a bid to contend with inflation. The reverse repo rate has increased from 3.75 per cent to 6.50 per cent and the repo rate is from 5.25 per cent to 7.50 per cent.

Over the past 12 months, the market has also seen substantial liquidity tightness for multiple reasons. It began with the 3G and broadband auction resulting in telecom companies borrowing aggressively from the banking system to fund the bids.
Then there were blockbuster initial public offerings (IPOs), in the form of Coal India Ltd, Power Grid Corporation of India and Manganese Ore. The amount of demand that these disinvestments attracted was huge and large amount of money was pulled out from circulation during these public issues. All these three IPOs collectively attracted more than Rs 3.80 lakh crore from the domestic investor.

Credit pick-up from other sectors also remained robust while the government held large cash balances. The credit-deposit ratio of the banking system was above one which meant that banks were lending more than fresh collection by way of deposits. With banks gasping for liquidity, deposit rates began to move up in order to attract fresh deposits to improve the liquidity and balance sheet ratios. To add to it, inflation was exceeding expectations and market rates started pricing in expectations of stronger hikes by the RBI.

Due to these multiple factors, the return on short-term corporate paper and certificates of deposit (CDs) went up. Since it is not possible for a retail investor to benefit from this, the next best option is either a short-term debt fund instrument or an FMP, both of which invest in such instruments.

Out of the 763 new fund offerings (NFOs) that have been launched since July 2010, 655 have been FMPs. However, the focus has been on shorter tenure FMPs that are looking at playing the volatility in short-term rates. Since April 2010, the number of FMPs with maturity of a maximum three months has been 189, while those with a tenure of at least 12 months have been 98.

Here are the issues that investors need to get clarity on before they invest in an FMP.
How liquid an instrument is it?
Not very. It is now mandatory for all FMPs to be listed on either the Bombay Stock Exchange (BSE) or National Stock Exchange (NSE). But it is not so easy to exit before maturity as buyers are tough to come be. So ensure that it is money you do not need for the tenure of the scheme.
Being close-ended in nature, would an investor face an issue if a dominant investor walked out?
This would have been a problem a few years ago. If a corporate was in need of cash, the exit load would be paid and the investor would walk out with his investment valued at current net asset value (NAV). The fund manager would have to sell the investments at a loss to meet the redemption requirement, a move that would impact the investors who stay on. Now such exits are banned. Investors, if they want to exit before maturity, will have to sell their units on the stock exchange.
How risky is it?
Much less risky than it was during the hey days of 2006 and 2007. At that time, FMPs were permitted to declare indicative portfolios and indicative yields. With a dozen FMPs clamouring for investors’ money and attention simultaneously, the one way to get noticed was to offer a higher indicative return. In the race for returns, credit quality was the casualty, which increased the risk of the investment. It did not stop there. Fund managers also began to take a gamble on the tenure of the paper. Ideally, the portfolio should sport paper that would mature at the same time as the scheme. But if the tenure of the paper was slightly longer than the scheme’s tenure, it could provide a higher rate. Just before the scheme matured, the fund manager would have to sell that paper. The risk was that if interest rates rose at the time of maturity, he would end up selling at a loss and the final return would be lower than the indicative return. In 2009, the Securities and Exchange Board of India (SEBI) banned mutual funds from announcing indicative returns and displaying indicative portfolios for their FMPs.
How efficient is it tax-wise?
In an FMP you pay long-term capital gains at either a rate of 10 per cent without indexation or 20 per cent with indexation (whichever is lower). If they mature within a year of purchase, short-term capital gains tax will be charged based on the existing tax slab of the investor. In the case of fixed deposits, the return is treated as income from ‘Other Sources’ and the normal tax slabs apply, irrespective of the tenure of the deposit.
Is the return guaranteed?
No. Unlike a fixed deposit you are not guaranteed a return. However, the risk is not high and this instrument can be clubbed into the medium to low category as far as risk goes. With the current returns for 90-day CDs at around 9.4 per cent and the one-year returns around 10 per cent, one can accordingly expect such a return from a FMP.

This column appeared in the July 2011 issue of Mutual Fund Insight. Click here to subscribe to Mutual Fund Insight.