There have been a slew of fixed maturity plans (FMPs) launched off late.
In 2003, 79 FMPs were launched. This number has grown steadily in the subsequent years. Last year as many as 108 fixed maturity plans were launched, while the current year has already seen the launch of 239 FMPs. Read on to find out the reasons for this new-found frenzy for FMPs and how can they can be a good option for risk-averse investors.
But before that, let us explain what exactly fixed tenure plans are. As the name suggests, these are closed-end funds with a fixed duration, which is specified at the time of the launch of the fund. At the expiry of the duration, the money is redeemed to the unit holders. The tenure of the FMP could vary from 30 days to 3 years or even more, thus catering to the needs of very short-term to long-term investors. Typically, an FMP invests in bonds maturing in line with the tenure of the fund. For example, a one-year FMP will invest in bonds, which will mature in one year. This characteristic of matching the fund's maturity profile with that of its bond holdings insulates them from interest rate risk. And this is why they can be a good option for bond fund investors, who have been left with fewer options in present times when there is a lot of uncertainty over interest rates.
Interest rates and bond prices are inversely related. As interest rates rise, the bond prices decline. And higher the maturity of the bond, higher will be the loss. Till 2002, the interest rates were heading southwards, and this translated into increase in bond prices and higher returns for income funds. The rule for fund managers was simple- higher the maturity of the portfolio, more will be the returns. Times were very favourable for income fund investors as they were able to earn double digit returns without taking any significant risk.
But subsequently, the interest rates started rising and the returns of income funds evaporated. Many bond fund managers were caught off-guard and the ones who continued to invest in long dated bonds suffered. Year 2004 was particularly harsh as many income funds delivered negative returns. As a result, investors lost faith in income funds and there were wide-scale redemptions from income funds.
It is here that FMPs can add value. Rather than worrying about whether to invest in an income fund with a long maturity profile or a short maturity profile, an investor can simply invest in an FMP whose tenure matches with their investment horizon. For example, a risk-averse investor who wants to invest for three years can simply invest in a fixed maturity plan having with tenure of three years. This way, his worries about rising interest rates and his fund incurring losses will get alleviated to a large extent.
This is because rising interest rates can only inflict you with losses if you plan to sell a bond before maturity. If you hold the bond till maturity, you will get the entire par value of the bond without any capital loss. This is exactly what a typical FMP aims to do. By investing in bond maturing in line with its tenure, an FMP is able to eliminate the risk of capital loss to a great extent and it will generate returns equivalent to the weighted average yield of its bond holdings.
Therefore, FMPs can be a good option for a bond fund investor to tide over the volatile interest rates. But bear in mind that these are close-ended funds your investment will get locked for the tenure of the FMP.