Should you consider investing in fixed maturity plans over others?
The Fixed Maturity Plan (FMP) is a favourite instrument of a lot of risk-averse investors. There are many reasons why these are popular. The FMP promises an indicative return on a specific date, almost like a fixed deposit (FD). The return will be higher than an FD.
Importantly, FMPs can juggle dates to get favourable tax incidence while minimising holding period. A debt fund that’s held for over three years is liable for long-term capital gains after indexation. This means considerable tax-savings for someone in the highest tax bracket.
An FMP can be designed to open in March at the end of a fiscal, and close out in April, just after a new fiscal begins. In theory, you could enter an FMP on March 31, 2020 and it would be set to mature on April 1, 2023.
This theoretical scheme would give the benefit of four years of indexation for your tax returns, even though you will only hold the instrument for just over three years. That is significantly advantageous compared to a FD, or short-term debt fund. Moreover, the LTCG tax rate is 20 per cent, post-indexation to inflation, at a rate computed by the IT Department. If inflation has been high, the actual tax incidence could be low. For example, if your return is say, three per cent higher than the indexation rate over the period, your tax incidence will be roughly 0.6 per cent of your returns.
FMPs are also “cheap” instruments with low fees and fund managers face no redemption pressures. A normal open-ended debt fund must trade debt with the associated costs, as interest rates change. The FMP will invest in debt instruments that mature near the scheme’s end-date and hold that portfolio. It can ignore interim interest-rate fluctuations.
On her part, the investor has comfort about the safety of the principal, since it is invested in debt instruments held to maturity. The indicative return can also be computed accurately since the FMP holds its corpus till maturity and the NAV gives a good indication of what the final return will be.
What are the downsides of FMPs, given the advantages cited above? One is zero-liquidity. It is extremely difficult, indeed near-impossible, to cash an FMP prior to date. So, don’t consider an FMP unless you know for sure that you won’t need the cash during the lock-in period.
The second problem is more serious. It is up to the fund manager to invest in “safe debt” and fund managers do make mistakes. FMPs seek higher returns by investing in corporate debt of various kinds, always with the proviso that the underlying debt matures close to the maturity date of the scheme. They often choose unsecured instruments like corporate paper and certificates of deposit.
The fund must rely on rating agencies and its own market intelligence to assess if the debt is good. This can go horribly wrong sometimes. We have seen trouble across the debt market in the recent past due to several defaults in highly-profile corporate debt. We have seen defaults from IL&FS group, Jet Airways, some Anil Ambani firms, and Zee-Essel Group.
It is the defaults by the latter that have hurt FMPs. At the time of writing, there is an ongoing crisis in FMPs because the Zee-Essel group has run into trouble with its debt servicing. Certain FMP schemes of Kotak MF and HDFC MF have been forced to hold back on redemption due to this. The Kotak schemes are offering only partial redemption while assuring investors that they will return the rest of the money as and when the Zee group repays its debts. HDFC has offered investors the option of rolling over for an extra year in the hopes that it can recover the debt. Sebi has taken note of this but it is not clear what will be the outcome.
Does this mean that FMPs have suddenly become terrible instruments? No. The advantages mentioned above remain. But investors must always bear in mind that there can be defaults even in blue chip debt. Yes, an FMP is usually safer than a debt mutual and it offers higher returns and more tax efficiency than an FD. But it is not zero-risk.
The author tracks economic, behavioural and corporate tends, hoping to gauge good avenues of return