Caution, FMPs too can go astray

Fixed Maturity Plans aren’t substitutes for bank deposits

Recently, investors in Fixed Maturity Plans (FMPs) of two fund houses were told that they may need to be a little flexible about receiving their maturity proceeds.

Kotak Mutual Fund redeemed its FMPs series 127 and 183 on maturity date, paying back capital while deferring part of the returns to a later date, citing a delay in realisation of debt from the Essel group. It also informed its investors about four other FMPs with exposures to the Essel group and the troubled IL&FS Transportation Networks.

HDFC Mutual Fund sought investors’ consent for extending the term of its 2016 FMP series 1168D by another 380 days and told them that it could either defer returns or seek a roll-over for other FMPs due later. Its note details 22 other FMPs that feature exposures to the Essel group. In all, over 50 FMPs from seven fund houses due to mature between 2019 and 2021 feature Essel exposures that expose them to similar risks.

How they work

To investors who are used to parking money in FMPs, the idea that these funds can postpone repayments or deliver poor returns may come as quite a shocker. FMPs in the market have delivered returns of between 7% and 9.5% in the last five years.

Over the past decade, FMPs have become an investment staple for investors seeking to avoid the high taxes on bank deposit interest and the rate risks of open-end debt funds.

If interest rates in the economy rise after you invest in an open-end debt fund, you may end up taking a capital loss because of the fall in bond prices. FMPs neatly sidestep this risk by exactly matching the maturity date of the bonds they hold with the scheme’s maturity date. While some FMPs play it safe by sticking to AAA or A1 rated corporate bonds, others go in for AA or A rated bonds to bump up their yields.

FMPs are also bought for their tax advantages compared to bank deposits. If held for three years or more, returns on FMPs are taxed as long-term capital gains at 20% with indexation benefits. FMPs with terms of just over 365 days, launched at the fag-end of each financial year also earn you the famous ‘double indexation’ benefits, where you get to adjust your cost for an extra year. The brewing FMP crisis is a reminder to investors that while FMPs may avoid interest rate risks, they do take on credit risks on corporate bonds that can sometimes backfire.

Lessons from the fiasco

The FMP crisis highlights three hitherto hidden risks in this product for investors. One, even FMPs that promise to maintain high-quality portfolios with AAA or A1 rated instruments aren’t immune to default risks. The IL&FS default has shown that even AAA or A1 ratings from Indian rating agencies can be fallible. Therefore, while you can check the offer documents and invest in FMPs that promise only AAA or AA-rated investments, that doesn’t completely insulate you against credit risks.

Two, FMPs can expose you to higher risks than open-end debt schemes by owning concentrated exposures in corporate bonds. The crisis-ridden FMPs have invested 10-20% of their portfolios in various Essel group entities, while open-end credit risk funds restricted their weights in the risky securities to 1-6%.

Three, since they are close-ended and attract more retail than institutional investors, there is less scrutiny into the investing decisions of FMPs than into open-end funds. In open end-debt funds, institutional investors tend to protest risky exposures by exiting the fund, a facility which close-ended FMPs don’t allow.

All these are reasons for avoiding FMPs as a class. However, it is a lesson for investors to stop thinking of FMPs as substitutes for bank deposits. Investors in ongoing FMPs must immediately check the portfolios of their schemes and watch out for any email communication from their fund houses on troubled bonds. Rolling over the fund, if given the choice, is your best bet though you may have to wait longer for your money.

Source: Read Full Article