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Monday, August 27, 2012

Invest Now In FMPs When Rate Cycle Is Peaking Out

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Fixed Maturity Plans Offer Better Returns Than Bank FDs, Especially When Rates Are High

In India, bank fixed deposits for long have been the proxy for investments in debt instruments. Of late, however, fixed maturity plans (FMPs) have become popular among retail as well as high net worth individuals. Some of the rea sons for this popularity include range-bound equity markets, the search for stable returns at a time when equities are not that lucrative and also the higher post-tax re turns over bank FDs. We take you through the basics of FMPs, how your fund manager invests and manages these funds and their tax advantages over FDs.


What are fixed maturity plans? - FMPs


Fixed maturity plans, commonly FMPs, are the passively managed close ended mutual fund schemes in which the portfolio is held till the maturity of the assets it has in vested in. Since FMPs are closed ended schemes, as an investor while putting your money you have a clear idea when the scheme will mature and you will get your money back. Seen from another way your FMP fund manager will in vest in bonds and debt papers whose maturity will match with the maturity of the scheme. So, for example, if you have invested in a one-year FMP, the maturity of the bonds and debt that it holds will also be exactly one year.


Also, while investing you know the duration and the type of fixed income assets the FMP is invest ing, you also invest with a very good idea about the return you will get at maturity.

 
How do FMPs work?


FMPs invest in debt instruments mainly certificate of deposits (CDs) and commercial papers (CPs). Of late, with investors showing their preference to invest in FMPs that invest in CDs, most fund houses are also offering FMPs that invest in these instruments. The most commonly offered maturity period of FMPs are 30 days, 180 days, 370 days and 395 days.

As FMPs invest in CPs and CDs, which traditionally have been lowrisk debt products, your investment also carries a very low risk. And since the assets are locked till maturity, there is no interest rate risk too. That is you will get a pre-determined return that the fund house had indicated when you put your money into it.


As an investor, one important point you should note here is that fund houses never guarantee returns, but will only give an 'indicative return'. This is purely to play by Sebi's rulebook that prohibits guarantee of returns in any mutual fund scheme.


To provide liquidity to the investors in FMPs, Sebi has also made it mandatory for all these schemes to be listed on the bourses, but practically almost no trading takes place in these schemes.


Suitability factors


If you are willing to lock in your funds for some time, a pre-defined period, you could consider investing in FMPs. In India, tenures for FMPs vary between 30 days and five years. But remember, as there is very low liquidity in FMPs, you are unlikely cash out of these schemes before maturity. FMPs are similar to bank fixed deposits (FDs), but carry lower liquidity. On the other hand, they give superior tax advantages over FDs. So, in effect, by giving up some flexibility in getting your money back when required, you get a better post-tax return in FMPs.


When to invest in FMPs?


FMPs are a good alternative to bank FDs for superior tax adjusted returns (see the accompanying article on tax treatment of FMPs). The best time to invest in FMPs is when interest rates are peaking out. So alternatively, it is not a very good idea to invest in FMPs when the interest rate cycle is rising.


Consider this: Suppose the prevailing rate in the economy is rising from 8% per annum to 9% and then going towards 10%. Then when it is between 9% and 10%, say 9.7%,signs emerge that it may not rise much from here. At this moment if you invest in an FMP with a one-year maturity, you would get 9.7% return.


Now, suppose the rate cycle actually reverses and starts coming down, from 9.7% to 6.75% in about two years time. If you had invested in a one-year FMP when the rate was hovering around 8%, you will get the same rate when it matures even if the prevailing market rate during the maturity is say 7%. So, you gain by one percentage point.


Suppose when the market rate is 6.75%, signs emerge that the rate cycle could soon turn. Still you invest in an FMP which gives you 6.75% over one year. Some time after you invested in the scheme, the rate cycle actually turns and during the maturity of the FMP it is 7.75%. Although the market rate is high, you will still get 6.75% — that is your return will be lower by one percentage point from the market rate.


So invest in FMPs when the rate cycle is nearing its peak or has just peaked out, but not when the cycle has just bottomed out.


Caveat


Fund houses never guarantee returns on your investments in FMPs. And these investments also come with credit risks, the risk of default on securities in their portfolios. Compared to this, bank FDs are guaranteed up to Rs 1 lakh per account and are relatively more liquid than FMPs.

 

Happy Investing!!

 

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