The rising interest rates in recent months has shifted focus onto a hitherto neglected investment category among mutual funds — fixed maturity plans (FMPs). Floated as close-ended mutual funds, these are investment schemes have maturity periods ranging from one month to five years.

Why they do what they do

The basic objective of FMPs is to generate steady returns over a fixed period, thus immunising investors against market fluctuations. FMPs are passively- managed fixed-income schemes; the fund manager locks into investments with maturities corresponding to the plan's maturity.

This effectively reduces price risks, or the potential to make losses on bonds when interest rates rise, unless there are interim redemptions by investors.

Investors are informed of the returns their investments are likely to generate at maturity. The prevalent yield on investments, minus the expense ratio, which varies from 0.25 per cent to 1 per cent of the initial capital mobilised, is the likely return at maturity to the investor. FMPs usually invest in certificates of deposit (CDs), commercial papers (CPs), money market instruments, corporate bonds, and even bank FDs.

The plans are predominantly debt-oriented, while some may have small equity components. In the case of FMPs with equity components, the equity provides an additional boost to returns in the event of a rise in the market.

Popular investment option

When interest rates first began to rise, there was an increasing allocation by mutual funds in floating rate funds.

The trend has now shifted to an increasing participation in FMPs. Around 400 FMPs were launched between April 2006 and March 2007. March 2007 alone accounted for more than 100 new launches.

FMPs vs FDs

FMPs are the mutual fund industry's equivalent of FDs, with a caveat: The maturity amounts of FDs are assured returns unless the bank issuing the FD is in financial distress, while the returns on FMPs are only indicative. However, FMPs are more tax efficient than FDs are.

A comparison of a one-year FMP (dividend option) and an FD of a similar tenure, for individuals, indicates that the post-tax returns are higher for FMPs than for FDs. This is because dividends are tax-free for the investor, though the mutual fund pays a dividend distribution tax of 14.16 per cent (inclusive of surcharge and cess).

In contrast, the interest gained on FDs is added to the main income and taxed as per the applicable income tax rate. For an individual with an income of over Rs 10 lakh, for instance, the tax on interest on FDs is 34 per cent (inclusive of surcharge and cess). Though the latest Budget has narrowed the arbitrage between the money market or liquid funds and bank FDs by raising the dividend distribution tax to 25 per cent, it remains unchanged for FMPs, at 12.5 per cent (both values exclude surcharge and
cess).

FMPs with growth options and tenors of more than a year can get the benefits of long-term capital gains, where the tax rate is at 10 per cent (without indexation benefits) or 20 per cent (with indexation benefits).

Investors can also get double indexation benefits by investing in an FMP in, say, March 2007 (financial year 2006-07), and redeeming the same in April 2008 (2008-09). In such cases, the incidence of tax is further reduced.

FMPs vs other debt funds

The principal difference between the regular debt funds and FMPs is in the risk profile. Other debt funds are typically exposed to three types of risk: risks relating to interest rate, liquidity and credit.

Interest rate risks arise when the fund constantly buys and sells bonds, thus exposing itself to interest rate fluctuations, which manifest themselves as the marked-to-market action on portfolio value.

Liquidity risks arise owing to the huge redemption pressures that result when the fund sells its holdings at short notice, and at times, even at unfavourable prices. Credit risks occur when risks of default on securities lead to valuation losses. FMPs, on the other hand, face only credit risks by virtue of being close-ended. Interest rate risks are ruled out because the fund manager holds most investments to maturity, thereby obtaining fixed
rates of return.

Liquidity risks are also minimised because funds are close-ended; the events for redemption of securities in FMPs are likely to be lower than that for other debt funds. Although there is a measure of liquidity risk involved in interim redemptions, this is minimised because most investors park their funds in FMPs to hold them to maturity.

The risks

The single greatest risk factor that FMPs face relates to the credit quality of their portfolios. The indicative yields declared by FMPs have increased over time. One of the ways FMPs increase their yields is by investing in credits that are not in the highest safety category.

As one moves down the rating scale, the yield on instruments picks up; this is the reward that investors get for being willing to take on higher credit risk. However, it is imperative that investors know how much credit risk they will take on by moving down the rating spectrum.

FMPs are not capital protection-oriented funds. The maturity amounts of FMPs are only `indicative,' and not `protected'. Investors could suffer losses on invested capital at maturity in the event of default in even one security. Investors, therefore, need to ensure that the FMP does not take on credit risk that is inconsistent with their risk profile.

Tools for investors

Credit risks in FMP investments constitute the investors' biggest risk. Reliable, third-party evaluations of credit risk will help them do so. In this context, services such as Crisil's CQRs (Credit Quality Ratings) provide an independent opinion on the overall credit risks associated with securities in a fund's portfolio.

FMPs provide investors with opportunities to register returns that are higher than those available with risk-free investments. However, investors need to be aware of the credit quality of the portfolio, and of the fact that high returns are possible only when there is no default in the underlying securities. In other words, credit risk monitoring is a key
imperative for FMPs.