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Sia, a young woman in her late 20s, believed in only one 'investment' - bank Fixed Deposits (FDs) . She had issued standing instructions to her bank to transfer funds in excess from her savings account into her fixed deposit account.
One morning, while Sia was going through her social media, she happened to see an advertisement about 'FMPs' and how they were better as compared to FDs. Feeling curious, she decided to do some more research online. Here’s what she found:
What are FMPs?
Fixed Maturity Plans or FMPs are close ended funds which invest for a fixed time period (tenure) in debt securities. These debt securities are issued by various companies (government and private) who require money for expansion of business or for working capital. The tenure of the FMP could range from 1 month to 5 years and matches the tenure of the debt securities the FMP invests in. For instance, in case of a 3-year FMP, the fund will invest in debt securities with a tenure of 3 years which protects the assets from market fluctuations.
Unlike other debt funds, the FMP fund managers follow a buy and hold strategy. There is no frequent buying and selling of debt securities, like in some other debt funds. This helps to keep the expense ratio of FMPs at a lower level as compared to other debt funds.
What are the advantages of FMPs?
FMPs have the following advantages:
1. Relative Safety of capital
FMPs normally invest in government & corporate bonds with good credit quality, commercial papers (CPs), certificates of deposits (CDs), thereby offering relative safety of capital.
2. Low interest rate risk
FMPs bear low interest rate risk, unlike other debt funds. Interest rate risk implies that when interest rates go up, the market prices of existing debt securities (which offer lower rates) fall, thereby resulting in a possible capital loss. On the other hand, if interest rates fall, market prices of these debt securities go up, which will result in a capital gain. In case of FMPs, the fund is locked in at the interest rate offered by the debt security till maturity, and hence, there is low interest rate risk borne by the fund. In other words, the investor's capital is protected.
3. Low trading cost
In case of a FMP, the fund manager does not frequently trade (buy and sell) debt securities, which means that he incurs low trading costs such as brokerage, taxes, etc. Hence, FMPs score over some other debt funds (income funds, gilt funds, etc) due to a lower expense ratio.
What are the disadvantages of FMPs?
Of course, like every financial instrument, FMPs are not perfect. One must keep in mind the following possible drawbacks while investing in FMPs:
- Not very liquid (if you wish to sell before maturity)
Exiting from a fixed maturity plan before maturity may be a bit of a challenge due to low levels of trading in these securities on the stock exchanges. Additionally, trades take place at a discount to the NAV of the fund. Hence, it's preferable to hold your FMP investment till maturity.
- Carries credit risk
FMPs carry credit risk (possibility of default of securities in their portfolio) and hence, investors should check the FMP portfolios for their credit rating, before investing.
- Does not offer guaranteed returns
Unlike Fixed Deposits, FMPs do not guarantee returns. While you may hear about indicative yields (returns) at times, these are never assurances or even to be used as the right guidance to make investment decisions.
What are the tax implications in FMPs?
The tax implication will depend upon the investment option you choose - growth or dividend option
Let's explore the growth option first
In the growth option the returns will be taxed as capital gains. Capital gains earned on FMPs when the investment is held for less than 3 years are considered to be short term capital gains, which are taxed at the rate applicable to the investor's total income. For instance, an investor in the highest tax bracket of 30% will pay tax on the capital gains on an FMP of tenure of up to 3 years at this rate.
Capital gains earned on FMPs when the investment is held for more than 3 years are considered to be long term capital gains, which are taxed at 20% after considering indexation (Indexation implies adjusting the purchase price for inflation growth). One needs to use the cost inflation index table published by the government every year to compute the inflated cost of your FMP investment. This usually helps reduce the taxable capital gains. In case of FMPs held for more than 3 years, an investor can enjoy triple indexation (i.e. inflating the cost over 4 years while actually having invested for 3 years). Here is how that can possibly work:
TABLE COMES HERE
*^The income tax department provides a Cost Inflation Index, (used for calculating long term capital gains ) table every financial year which increases the cost of your investment to the extent of inflation.
Indexed cost means the inflated cost (actual cost increased based on the inflation rate specified in the
CII table in the year of purchase and year of sale)
@Capital gain means the profit on sale of the investment (sale value minus inflated cost)*
From the above example, you can see that even though you have held the investment for 3 years and 1 month, your investment cost is inflated for a 4-year period, which results in a lower amount of capital gains tax, applicable to you.
Now let's explore what happens if you choose the dividend option:
In this option, the fund house pays DDT (Dividend Distribution Tax) at the rate of 29.12% (this includes surcharge of 12% and health and education cess of 4%) before paying out the dividend. This means, when the dividend is paid out to the investor, he doesn't need to pay any additional tax on it.
Using FMPs to meet financial goals
Since FMPs are of a fixed tenure, you can invest in an FMP which has a tenure matching that of your financial goal; for instance, if your financial goal is due after 3 years, you could invest in a 3-year FMP keeping in mind the amount you're investing and what your approximate target value is.
In conclusion, FMPs are suitable for investors who want to avoid interest rate risk and are willing to stay invested for the entire period of the FMP in order to reap the tax benefits offered, while meeting a financial goal.