How mutual funds strip reinvestment risk from FMPs

Go for STRIPS FMPs only if you are sure of your investment horizon and can park the money for the entire tenure of the FMP.
Go for STRIPS FMPs only if you are sure of your investment horizon and can park the money for the entire tenure of the FMP.

Summary

  • STRIPS break down a bond into multiple securities, representing coupons and principal.

Kotak Mutual Fund, ICICI MF and DSP MF recently launched fixed maturity plans (FMPs) which will invest in government securities (G-Secs), but there is a twist.

These FMPs will invest in STRIPS of the G-Secs, rather than the G-Secs themselves. Here is a look at what these STRIPS are all about.

Reinvestment risk

When it comes to investing in bonds, interest rate risk, credit risk, liquidity risk, etc. are usually what concern investors, but there is one risk that rarely gets talked about – the reinvestment risk.

What is this? When you invest in a bond, apart from the principal payment at the end of the bond’s maturity, you also receive coupon payments, typically semi-annually (twice a year).

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The investor may or may not be able to reinvest these coupon payments at the same yield offered by the original bond as yield movements can fluctuate, depending on market dynamics.

How are STRIPS created?

STRIPS stands for Separate Trading of Registered Interest and Principal Securities. It is a process that breaks down a bond into multiple securities, with each security representing a cash flow, payable when it is due.

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For example, when 100 of 6% G-Sec 2026 is broken down, each coupon payment of 3 (payable semi-annually), will become a coupon STRIP and the principal payment of 100 (payable at maturity) will become the principal STRIP (see graphic).

These cash flows are split into separate securities and are traded in the secondary market as STRIPS. The STRIPs' maturity coincides with the date on which the coupon or principal payment was due. For example, if the first coupon was due in six months, that particular STRIP would also mature in six months.

These STRIPS are in effect zero-coupon bonds (ZCBs). As there are no coupon payments on these securities, the risk of reinvesting at lower yields gets eliminated. The bonds are converted into STRIPS by primary dealers, who charge 2-4 bps to create STRIPS. At present, this process is only allowed for G-Secs.

Who should go for FMP STRIPS?

FMPs are close-ended funds. So, investors getting into FMPs need to wait till the fund matures. If yields or interest rates move downwards, reinvestment risk can shave off 20-30 basis points (bps) from the returns indicated originally.

For investors who are not sure if they can stay put over the fund’s maturity, target maturity fund (TMF) can be an alternative. The investor will have to trade in the reinvestment risk to access the liquidity in TMF.

There is option to withdraw before the maturity of the fund, as TMFs are open-ended. While early withdrawals are allowed in TMFs, investors may not get returns close to indicative yield on such exits.

Go for STRIPS FMPs only if you are sure of your investment horizon and can park the money for the entire tenure of the FMP.

Ankit Gupta, co-founder, BondsIndia, has an additional tip. “See the level at which you are investing in STRIPS and what is the interest rate outlook. Are the rates likely to move downwards from current levels? Then STRIPS make sense."

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