Investing in fixed maturity plans

If you are looking at debt exposure in your portfolio then FMPs are a good option.

Inflation is a big challenge for many people these days. More so for senior citizens. They are dependant on the income from their investments,to take care of their expenses. In the retirement phase most of them keep a bulk of their investments in safe debt instruments,to ensure that there is no erosion of capital. That means most of their investments would be in FD,Bonds,NSC,KVP,Post office MIS etc. But keeping the investments in debt instruments have their downside as well.

The returns from debt instruments are fully taxable (except in case of PPF/PF). Hence,the net returns are not that attractive,even if the returns seem to be attractive on the face of it. Secondly,the post tax returns may not be able to beat the inflation and will result in degrowth of capital for the investor. This poses a serious problem for someone who has a limited corpus and due to inflation,it keeps growing smaller and smaller.

That is where,Fixed Maturity Plans (FMP) will score. FMPs are debt instruments coming from Mutual Funds. FMPs invest in Commercial Paper,Certificate of Deposits,Debentures,Bonds,Securitised debt,Money Market instruments etc. So,an FMP is also a 100 per cent debt instrument. What about the returns in an FMP? There is no guarantee of a fixed return in an FMP,unlike in the case of FDs/ bonds. This is somewhat unnerving for some investors. There is more…

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As per SEBI regulations,the portfolio and the indicative returns of the FMP cannot be disclosed by the Mutual Fund house. This has ostensibly been done so that they do not show one portfolio and invest in a different portfolio. Also,the ban on disclosing indicative returns has come in place as this return can vary with the portfolio that is ultimately chosen for that FMP.

In the absence of this information,it became difficult for a person to decide whether a particular FMP is a good candidate to invest. So now,one has to do a bit more guesswork on the portfolio and can also access FMPs that have come in the recent past. They will give a rough indication of what kind of portfolio a new FMP may have.

If you notice the FMPs which have come in the recent past and have noticed their portfolios,you would have noticed that their composition consisted of Bank CDs. This seems to be a trend these days. Bank CD rates are at a median of 9.6 per cent,for about one year tenure. You could safely assume that the return will be more or less that,as the portfolio is held to maturity and is not subject to interest rate risk. Then there would be expenses,which could be about 0.3-0.4 per cent,on an average. Reducing the expenses,the gross return comes to 9.3 – 9.4 per cent. There are Bank FDs too,which offer these gross returns. What turns the tables in favour of FMPs is their tax treatment.

A debt MF scheme,which includes an FMP,is eligible for long-term capital gains treatment after 365 days of investment. Long term capital gains is calculated at 10 per cent without indexation or 20 per cent with indexation,whichever is less. Indexation concept is used to compensate for the effect of inflation and to apply tax only on the real income earned and not on all the income. So,if an FMP starts in the current year and matures in the next financial year,it is eligible for single indexation. If however,it originates this year and terminates in the third financial year ( 2012-13 ),it will be eligible for double indexation benefit where the inflation adjustment can be for two years.

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Let us calculate using an example. Suppose Ram has invested Rs 10,000 in a 370 day FMP,which commenced on 1/2/2011. It will mature on 6/2/2012. Let us assume the inflation in this year is 8 per cent and the Cost Inflation Index reflects this,and the portfolio invested after expenses returns 9.4 per cent. To calculate the longterm capital gains,we take 10 per cent without indexation,which comes to 8.46 per cent. Now with indexation,the invested amount is treated as 10,800 and the amount you get back is 10,940. The gains made by you is Rs 140. The tax is 20 per cent on this amount,which comes to Rs 28. Now,the final amount that you get as returns are Rs 10,940 Rs 28 Rs 10,912. The returns are hence 9.12 per cent. As opposed to this,in case of FDs,Bonds,NSC etc.,the amount earned is directly added to the income and tax is applied. Even if an FD yields the same 9.4 per cent,the post tax returns would be just 6.5 per cent instead of 9.12 per cent in FMPs.

This situation may not be available in future. It would be a good idea to benefit from it now. Its advantage to you

with FMPs.

Author is President,Financial Planners Guild,India