Home >Money >Personal Finance >Understand the risks before investing in fixed maturity plans

Fixed maturity plans (FMPs), which are a close relative of fixed deposits (FDs), have fixed opening and maturity dates, and if they are held to maturity, they give predictable returns. However, FMPs are exposed to a lot more credit risk. As aggressive credit bets in FMPs soured, the industry itself turned away from them. Launches of close-ended funds (most of which are FMPs) plunged from 526 in FY19 to just 94 in FY20, data from Pulse Labs showed. Due to their FD-like nature, FMPs were prone to mis-selling. But it’s not just FMPs, other close-ended funds have also been mis-sold in the past.

The case of Kashinath Chaudhari, 61, a retired textile worker in Surat illustrates the depth of the mis-selling problem. Chaudhari was sold a close-ended hybrid fund. This sort of fund invests in equity and debt and is not an FMP. However, the trouble with this scheme happened on its debt component, from a default that also hit pure FMPs. "We received a postal life insurance cheque of around 4 lakh, on the death of my mother. This money was the sole life saving of my father. After they cleared the cheque, SBI branch officers called my father to the branch. They told him to invest in this product because it was just like an FD and would give 10% interest and would not have any tax deducted at source (TDS) or tax payable on maturity. They did not say anything about the risks in the product or assess my father's risk profile," said his son Mihir Chaudhari, 27, who has been highlighting the case on social media.

The fund, SBI Dual Advantage Fund Series XXII, a close-ended hybrid fund launched on 24 May 2017 is set to mature on 27 May 2020 with a compound annual growth rate (CAGR) return of just 2.22%. The reason for the sub-par return is a default in Reliance Home Finance Ltd (RHFL), an ADAG group company. “RHFL constituted about 9% of Dual Advantage Series 22 maturing on May 27, 2020. SBI Mutual Fund has duly filed an application through the Debenture Trustee with the National Company Law Tribunal (NCLT) to recover all amounts due on these NCDs. The matter is sub-judice," said a spokesperson for the fund house. A letter written by SBI Mutual Fund to Sebi in December 2019 also alleged fund diversion and fraud in RHFL. Mint has seen a copy of the letter. However, a forensic audit by Grant Thornton delivered no 'adverse findings', media reports from January 2020 said. The State Bank of India did not respond to Mint’s emails on the matter.

Other fund houses have also taken similar hits on their FMPs. Repayment problems in the Essel Group in 2019 resulted in several AMCs entering into a standstill agreement to not enforce their securities against the borrower, a nine-month period till September 2019. However, this caused problems in FMPs that were scheduled to mature before the extended debt timelines. In one case, HDFC AMC rolled over (extended) its FMPs. The fund house subsequently took the troubled paper from the FMPs onto its own books. Kotak AMC also delayed the maturity of an FMP, which it subsequently repaid. Capital markets regulator Sebi initiated adjudication proceedings in the matter and HDFC AMC paid an amount of 4 crore. It is not clear if Kotak AMC has paid a similar amount.

So how should investors look at FMPs? An FMP has four advantages. First, by investing in corporate debt it can generate slightly higher yields than fixed deposits for those willing to walk that extra mile of risk. Second, if held to maturity, the return is predictable.

While fund houses cannot officially declare the yield beforehand, the yield is broadly estimated from the expected portfolio credit quality declared at the time launch. Third, it is more tax efficient than FDs due to the lower rate of long-term capital gains tax (20% with indexation) for FMPs with a term longer than three years. Fourth, its close-ended structure avoids the kind of redemption surge that led to the sudden winding up of six Franklin Templeton Mutual Fund schemes in April 2020.

However, FMPs also come with three major disadvantages. First, their small size allows them to only hold a few debt papers. If one of these papers goes bad, the FMP suffers a major blow to its net asset value (NAV) and the yield that the investor expected at the time of investing will not materialize. Second, if the papers are downgraded, investors cannot exit before the downgrade turns to default. Finally, if an investor needs to withdraw money for emergency needs for financial goals, an FMP does not offer him the liquidity to do so. Though the units are mandatorily listed on stock exchanges, there is very little trading volume in them. They also typically trade at prices that do not accurately reflect the NAV of the scheme.

However, credit concerns have not turned financial planners away from FMPs. “FMPs, which invest predominantly in AAA paper, will not be a huge risk. Very few AAA debt papers with some prominent exceptions such as IL&FS and DHFL, have defaulted. FMPs also have a tax advantage over FDs," said Amol Joshi, founder, Plan Rupee Investment Services. “That said, I have never recommended any FMP to any client. Their lack of liquidity is a major negative in my eyes," he added.

Interestingly, Joshi also pointed out the competition posed to FMPs by the new Bharat Bond series of debt funds. These funds have a ‘roll down’ concept of debt, which mimics the FMP idea of holding a paper to its maturity. This also takes away interest rate risk for those whose time horizon matches the maturity of the fund. “Some of the FMP investors will go to Bharat Bond ETF, which only invests in PSU debt. However, there are only two such ETF variants so far and two more have been proposed. It will take some time for this product to mature," said Joshi.

Investors should be cautious about FMPs as covid-19-driven economic disruption threatens to cause further defaults. Large segments of borrowers are currently under RBI moratorium, but this pause on default recognition may not continue indefinitely. The small size of FMPs and their inability to hold more than a few papers magnifies this list. The portfolio of an FMP is also not disclosed beforehand, only the indicative credit quality is mentioned. This is in contrast to open ended debt funds, where you know what you are buying. Investors who want to reduce interest rate risk can look at the Bharat Bond funds as an alternative.

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