Every year, in the last quarter of the financial year, a series of fixed maturity plans (FMP) are launched by asset management companies. These are essentially close-ended income schemes, with a fixed maturity date, that is , they run for a fixed period. This period could range from 15 days to two years or more.
Typically, FMPs invest in Certificate of Deposits (CDs), corporate bonds, money market instruments, etc. If an FMP is a 13-month scheme, it would invest in 13-month bonds . Hence, an FMP would carry almost no interest rate risk, meaning the value of your investment would not go down if interest rates on corporate bonds move up.
SAFE, BUT...
At the same time, one must understand that an FMP is different from a fixed deposit (FD). An FD is very safe and insured to the tune of Rs 1 lakh. Yes, if a bank goes bust, your FD is exposed to credit risk. However, there is a remote chance of a well-capitalised banks to sink. In India, a bankrupt bank is taken over by a bigger bank and its liabilities are also passed on.
FMPs are also exposed to a higher credit risk, as the payment on maturity depends on the underlying investments in the scheme. Therefore, it is important to study a scheme before investing in it. Make sure corporate bonds that are a part of the scheme are rated AAA or AA. Avoid FMPs that compromise on the portfolio quality to give a higher yield. After the 2008 slowdown, the Securities and Exchange Board of India (SEBI) asked mutual funds to not disclose yields (interest rates on the bond portfolio) on investment and the portfolio. Now, fund houses have been very discreet with their disclosure of the portfolio, bond yields. Even during the financial crisis, no FMP has defaulted. All have paid the promised rate of interest.
TAX ADVANTAGE
The pre-tax yields in 2008 were as high as 10-11 per cent for most FMPs, whereas today the yields stand at 7-7.5 per cent a year. FMPs which invest only in bank CDs are giving an annual return of 6.8 per cent.
The biggest advantage of an FMP is its tax arbitrage when compared to FDs. An FD would typically give an interest income which is taxed as per the applicable tax slab. If you fall in the highest tax bracket, you pay 30.9 per cent tax on a bond which gives 8 per cent. This means a bond giving you a pre-tax return of 8 per cent would give a post-tax return of 5.5 per cent.
On the face of it, the returns look decent but real returns, post inflation and tax, can lead to capital erosion over time.
| Debt Investment | Return (%) | Risks | Taxation | Liquidity |
| Fixed Deposit | * 6.5-7.25 (lower for short- term deposits) * PSU banks give higher rate * Corporate deposits offer 8.75-9.25 (3 years) | Insured up to Rs 1 lakh only | Interest added to income, taxed as per applicable slab | Interest deducted on withdrawals |
| FMPs | 6-11 | Credit risk (riskier than FDs) | * Interest is non-taxable * DDT or capital gains tax applicable (lower than income tax) | 0.5-2 exit load before maturity |
Therefore, debt investments must be done but the focus should be on maximising real returns or returns post inflation and tax. Hence, opt for debt investments that are tax-free or give tax advantage.
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A preferential tax treatment boosts an FMP's return by 1.5-2 per cent over an FD for someone in the highest tax bracket. This means you get a high, 35-40 per cent, post tax return through an FMP. Being a mutual fund scheme, it gives you income in the form of dividend or capital gain. Hence, the taxation for both dividend and capital gains are far lower than the highest rate of income tax.
However, you must make a wise choice on whether to opt for a growth option or a dividend option. If investing in an FMP with a tenure of less than 12 months, go with the dividend option, as the short-term capital gains in the growth option is much higher and removes any tax arbitrage. If opting for a scheme of over 12 months, choose the growth option. Even in the growth option, sometimes it is best to go for the one with indexation computation of tax. For, in most cases, the pre-tax yield here turns out to be the post-yield, as there is no or negligible tax liability. FMPs are good debt investment options for someone in the higher and highest tax brackets.
The writer is director, My Financial Advisor
