Why are short-term FMPs on the rise?

Short-term fixed-maturity plans (FMPs) are back on the investing radar. The last two months have seen prominent fund houses such as Aditya Birla Sun Life Mutual Fund, Axis Mutual Fund, Kotak Mutual Fund, Nippon India Mutual Fund and SBI Mutual Fund launch over a dozen such FMPs.

But before we delve into the reasons behind their resurgence, it's essential to know what FMPs are. They are closed-ended mutual funds that primarily invest in debt instruments. Simply put, the money invested in FMPs is locked until maturity. This protects your investments from interest rate fluctuations and offers a degree of predictability in how much return you get. So, when the interest rates are high, investors can lock in their money at higher rates.

In the past, FMPs used to be a prominent debt fund category, especially among large corporations and high net-worth individuals (HNIs). However, loan defaults by DHFL and Essel Group caused them to fall out of favour with investors.

Why the sudden interest in FMPs?

There are two reasons why FMPs with a maturity period of less than a year are becoming increasingly popular.

First, robust credit growth in the banking sector has led to a significant increase in short-term yields of debt instruments. For instance, the yield on a three-month certificate of deposit (CD) has surged from 7 per cent to 7.5 per cent in recent months. Similarly, the returns on a three-month commercial paper have moved up from 7.5 per cent to 8 per cent.

Devang Shah, Co-Head, Fixed Income, Axis Mutual Fund, also concurs: "We have observed stronger credit growth in the last two quarters, which is outpacing the deposit growth, which has been one of the main reasons for the spike in short-term yields."

Given the rising interest rates on debt securities, FMPs have become a lucrative investment option.

Second, even though the Reserve Bank of India (RBI) has kept liquidity tight since August-September 2023, operative or overnight rates have jumped from 6.50 per cent to 6.75 per cent.

Since interest rates are high right now, isn't it better for fund houses to launch long-duration FMPs rather than short-term FMPs? We explore why this is the case.

Popularity of short-term FMPs

Most FMPs launched recently are short-term funds with a maturity of less than 100 days. As per Deepak Agrawal, CIO-Debt at Kotak Mahindra AMC, "Due to tight liquidity and rates inching higher, the certainty of realising higher returns over liquid funds is lower. So, for investors, it makes sense to invest in FMP for a period of three to four months, which largely follows the 'hold-to-maturity' principle, and investors broadly end up realising the YTM (yield-to-maturity) net of expenses."

Agrawal further adds that short-duration FMPs have an edge over long-term FMPs as they offer various benefits. As indexation benefits have been removed, there is no incentive for corporates to invest in longer-duration FMPs. Moreover, if they want to invest for two or three years, open-ended short- to medium-term funds or target maturity funds (TMFs) are more suitable, since they provide the flexibility to withdraw money at any time.

Our take

When it comes to investing in debt, it is best to keep things simple.

A significant drawback of FMPs is that they are closed-end funds, meaning that investors cannot make withdrawals if they require money urgently. However, if you are keen on parking your money in debt funds and have a specific time frame for investing, target-maturity funds (TMFs) are a good option as they are open-ended, allowing you to access your funds at any time.

If your investment horizon is less than a year, liquid funds are suitable. And if you want to invest for one to three years, opting for short-duration debt funds is better.

Also read: Four mutual funds that went from zero to hero