(iStock)
(iStock)

Clues to help decode if an FMP is good for you

  • Know the risk associated with FMPs and how it can affect your returns
  • A well-researched and carefully selected FMP bond portfolio will give investors a lower risk debt fund option

Fixed maturity plans (FMPs) have always been presented as a tax-efficient alternative to bank fixed deposits (FDs) that provide assured yield and eliminate interest rate risk. However, it was never highlighted that if the money invested in bonds is not returned by the borrower, or the fund house, on maturity, then the capital invested itself is at risk.

This is what investors in the Kotak FMP 183 Series learnt when they received less than the face value of 10 after more than three years, with the promise of more but only if the promoters of ZEE Entertainment Enterprises Ltd pay up on their obligations in September 2019.

So what could the investors have done differently to protect themselves? Here are a few things to keep in mind while choosing an FMP.

Tenure matters

As closed-ended funds, FMPs lock up investors’ money for the tenor of the scheme. This helps them manage interest rate risk by holding securities in the portfolio to maturity without having to worry about redemption pressure that open-ended funds face.

Investors need to align the tenure of the scheme to their own investment horizon and only park those funds that they know they will not require in the intervening period. “The investment horizon, need for locking-in the current yield and the credit profile are important factors to consider while recommending an FMP," said Roopali Prabhu, head, investment products, Sanctum Wealth Management Pvt. Ltd.

(Mint)

The tenor of the FMP also becomes important from the tax point of view. One of the selling points of an FMP is the indexation benefits that are available for long-term capital gains, which result in better post-tax returns as compared to bank FDs. But this is available only for tenors of more than three years.

Look for clues

In an FMP, the portfolio is not known at the time of making the investment. Investors have to go by the details of the portfolio allocation and the type of securities that the fund discloses in the scheme information document (SID). But this may still not be enough to judge the risks in the final portfolio. While the SID may indicate the fund will not invest more than 30% of the portfolio AA-rated securities and the rest in AAA-rated securities, the risk in the fund will depend on whether the exposure to AA-rated papers is 10% or 30%.

“The investment philosophy of the fund house can be judged from its existing portfolios and track record in dealing with issues of safety," said Melvin Joseph, a Sebi-registered investment adviser and founder of Finvin Financial Planners. The portfolios of other FMPs and debt funds managed by the manager may give clues to how much risk the fund may take.

Look beyond the credit rating for a better idea. A fund that invests only in government securities has negligible credit risk. At the next level on the safety ladder is debt instruments of banks and PSUs and then private companies.

Looking at previous portfolios can also give you an idea about the fund’s concentration on securities. High concentration puts you at greater risk in the event of a default. Look at concentration across issuers and types of debt instruments.

Find out the extent to which the fund may take exposure to unlisted and privately placed securities. These are high on risk since the extent of disclosures and regulatory monitoring is limited here. Also, these are illiquid instruments which makes it difficult for the manager to exit in the case of a credit event.

Get real on returns

Investors need to get realistic about the indicative yield in an FMP. It is unlikely that all the bonds in the portfolio will mature at the same time as the FMP. This means that there is some reinvestment risk, i.e. the money may be reinvested at lower rates, affecting the total yield, even if the reinvestment is for a short period.

There is also the chance of default, like in the case of the IL&FS bonds held by many FMPs that had to be written down. This will also affect the yield from the FMP.

Low inflation rates will also have an impact on the post-tax return from FMPs because the benefit of inflation indexation will be low, which means the advantage FMPs had over bank FDs will also be lower.

Mint’s take

Do these episodes of bad debt negate the FMP as a debt product? Not if you do the due diligence before you invest, are sure of your ability to lock up the funds and are realistic, if not conservative, about risk and returns. “There is still merit in the product. You just need to know how to use it and do more homework on the portfolio: what kind of paper, concentration norms followed, covenanting standards of AMCs and others," said Prabhu.

“Investors should be educated that it is not a fixed deposit. It is a product for evolved investors who are able to understand the risks involved and deal with them," said Joseph.

Investors who don’t want to lock in the return should opt for open-ended funds that meet the same rigorous evaluation of portfolio and performance. The liquidity that open-ended funds provide is an important risk-management tool if the fund does not adhere to the expected performance standards. Open-ended funds that are held for over three years also get the same benefit of indexation for long-term capital gains that FMPs do.


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