Dhirendra, let's start with a basic question - what are fixed maturity plans (FMPs)?
Dhirendra: They are debt funds. But unlike open-end funds, these funds come with a term. They are designed like a fixed deposit. Investors invest and they can take their money out only at maturity, not in between. Their term is defined at the outset.
The advantage of investing in FMPs is that their returns are relatively more predictable. Since the money is locked in until a specific date, the fund manager buys and holds bonds whose tenure coincides with the expiry of the term of the FMP. So, the returns of an investor are equal to the coupon rates of the underlying bonds unless any of these bonds defaults.
See, a bond investor has to look at 2-3 things. One is the time period or the tenure of the bond. The other is the coupon rate or the interest rate. If the bond is of poor quality, it will get you higher interest. And if it is of very high quality, it will get you lower interest. Here you know the coupon, you know the time period and you know what quality it is. And since it is a portfolio of bonds, you are able to diversify your risk.
How is it different from a fixed deposit?
Dhirendra: In a bank fixed deposit, returns are guaranteed. In an FMP, the returns are not guaranteed but they have generally been higher than those of the comparable fixed deposits at that time. The returns of an FMP depend upon the combination of bonds it holds. All the returns accruing to these bonds, after the deduction of the fund's expenses, are investors' return that they get at the end.
So, why are FMPs in the news these days?
Dhirendra: The problem is that FMPs try to optimise returns. So, they invest a part of the money in very high quality to reasonable quality bonds, say, AAA and AA bonds. And then, they put in a small part of the money, depending on their own judgement, in lower rated bonds to optimise return.
Here's how the FMP story has unfolded in recent months. Many funds had exposure to certain securities that might be on the verge of defaulting. They did not honour their commitment to give the money back on time. Two of the Essel Group companies had borrowed money but they were unable to repay. Additionally, the promoters of those companies had pledged their shares (worth around Rs 13,500 crore) in Zee Entertainment as collateral to borrow the money.
Now when they failed to honour the commitment to repay, a few lenders sold Rs 200 crore worth of Zee shares held by them as collateral. It led to a 30% drop in the stock price of Zee.
So, mutual funds realised that if everybody started selling the collateral, the stock price would collapse and everybody would lose money. So, mutual funds collectively decided not to sell the collateral but instead try to get the money back by negotiating.
Hence, they talked to the promoters, who asked for time till September 30, 2019, to repay the money to the lenders. Given this, all the lenders, with one being Kotak FMP that has been in the news, now have to wait till September 30. That's why, Kotak FMP has been able to redeem the remaining bonds held by it and repay that money to the investors, which is about 85%. The remaining 15%, which is stuck in the bonds we have just discussed, is held back and would hopefully be repaid by September 30, once promoters pay their dues.
It is to be noted that the fund company still has the option to sell the Zee shares in the market, which it continues to hold as collateral. So, let's hope that investors do get their remaining money back as well.
How bad is the situation? Is there anything to worry about?
Dhirendra: It is not all that bad. But the entire episode was disappointing for investors, as many of them bought these FMPs considering them to be as safe as fixed deposits. They lacked an understanding of the risk factors associated with FMPs as well as the fact that they might not necessarily yield high returns.
Otherwise, the situation is not all that bad because when I look at all FMPs, there are about 30 FMPs that have nominal to meaningful exposure to these bonds. There will be a delay in the full repayment, subject to the resolution, to their investors. There is a possibility that they may not even get all the returns. But it is not that their money has vaporised completely. It is not a debacle. It is not a catastrophe that you have invested Rs 5 lakh and you are not getting any of your money back.
So, will the investors get back the money that has been retained?
Dhirendra: Maybe or maybe not. Maybe to a reasonable extent. The promoter has said that he is planning to sell his company and if he is able to do so, he will honour all his commitments. Also, the collateral is of some intrinsic worth. So, I'm hopeful. But it's not done till you get your money back and therefore, there's understandable anxiety among investors.
But at the same time, it is to be noted that fund companies have been able to go back and re-negotiate a higher return for the delay. For the six month period of the residual money that is stuck, they will get a higher return from the issuer.
From a broader perspective, I'd say that the vast majority of the FMPs redeemed in the last one year have provided a decent experience to investors. With most of them being reasonably rewarding, I think the real problem is with bankers or anyone else who set the wrong expectations while selling these funds to naive investors. This has to be tightened.
What's the lesson for investors in this? And perhaps is there a way to safeguard?
Dhirendra: No. There is not a way to safeguard but there is a lesson. Most fixed-income investors look at the highest yielding FMP of a company and then, invest in the new one. When investing in a fixed income fund, no extra return comes without assuming greater risks. And the risk doesn't visit you every day. But once in a while when it does, it hurts you.
So, avoid the best-performing, highest yielding FMPs. Also, don't just invest in one FMP. Spread it in two or three.
Besides, an investor can completely do without FMPs and invest only in open-end bond funds where you are at liberty to take your money out at any time. There is no lock-in. And I don't think there is a great compromise on return. Many of the funds are actually able to deliver similar returns. I would say that it is very important to choose a fund where your principal is not at stake for marginally higher returns. I don't find that the pay-off for assuming greater risk is good enough.
So, should one stay away from FMPs?
Dhirendra: I would say that the needs of most investors are fulfilled by better products, that is, open-end funds where you can walk-in or get out any time. They are well managed. I don't like the lack of liquidity. It is a compromise.
It also brings in far greater accountability on the fund company. They conduct differently. When they are running an open-end fund, they have a far greater responsibility.
FMPs would still be there because they strike a chord with a lot of fixed deposit investors. Mutual fund companies, salespeople, distributors and banks are able to pitch these funds as something that is similar to a fixed deposit. And most of them have succeeded. They have delivered returns. But most thoughtful investors can do without FMPs.
Will the FMP mess bring about a change in the conduct of mutual funds?
Dhirendra: Yes. One, they will be acting more prudently, which means they will not have large allocations to something that can land into trouble. They will still be assuming the risk because the whole idea of investing in a mutual fund is to improve your return.
There is also a possibility that many of these practices of promoter share-backed collateral will be checked. Because this is a fundamental issue - you have given something as collateral whose value changes every day. So, the sanctity of that collateral is in question. We have to see how it evolves. It has been disappointing but I don't think it is a calamity.
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This article was originally published on April 24, 2019.
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