FMP’s a better alternative to Fixed Deposits

FMP stands for Fixed Maturity Plan. These are essentially close-ended income schemes with a fixed maturity date i.e. that run for a fixed period of time. This period could range from one month to as long as three years or more. When the fixed period comes to an end, the scheme matures, and your money is paid back to you.

Some of the FMPs do invest a small portion of portfolio in equity which are called dual advantage fund. The portfolio is generally invested in debt and money market instruments maturing in line with the tenure of the scheme. The objective is to lock-in the investment at a specified rate of return thereby immunizing the scheme against market fluctuations.

Liquidity

In most open-ended mutual fund schemes, one can redeem one’s units anytime. However, the structure of the FMP does not lend itself to this kind of liquidity. In FMP Invest money you are more or less sure you are not going to need during the tenure of the plan. If you withdraw before the scheme closes, generally it is not permitted however you can sell it in the secondary market as all the closed ended scheme have to be listed in stock exchanges although finding a buyer for these securities is bit difficult. Though income schemes invest in similar instruments as an FMP, being open-ended and not having a specific tenure based investment strategy, these are subject to interest rate risk leading to fluctuations in the NAV.

What is better — A Bank Deposit or a FMP?

Lately the interest rates on bank deposits have fallen leading many investors to wonder whether a simple Bank Fixed Deposit (FD) would serve better than having to go through the process of investing in an FMP. Though compare to Bank FDs , FMPs currently offer a little higher rate of return; the tax impact tilts the scales in significant favour of the FMP.

Interest on Bank FDs is fully taxable whereas the return from FMPs is either subject to the Dividend Distribution Tax (for the dividend option) or the capital gains tax rate (for the growth option). The capital gain is calculated after adjusting with Cost Inflation Index. The Distribution Tax rate @28.84% or the capital gains tax rate @20% are lower than the income tax rate, especially in the case of investors in the higher tax bracket where income tax on interest will be at 34.60% (30%+12% Surcharge and Education Cess). Tax directly eats into returns, which is why FMPs have the edge over Bank FDs.

Are FMPs for you?

If you are looking for a fixed income avenue that yields a reasonable return with minimum risk, adequate liquidity and tax efficiency, FMPs will provide you with an effective shelter.

Let’s see how a longer termed FMP (of over one year) has an even better edge than a Fixed Deposit. The reason is that for an FMP of over one year, the return is taxed as long-term capital gain and not normal income. The following table summarizes the advantage that an FMP has over a fixed deposit.

In the case of an FMP, you have an option of paying tax on long-term capital gains @20% after indexing cost while for interest income you have to pay the tax as applicable to your tax bracket.

S. No.	Particulars	FMP of Mutual Funds	Fixed Deposit
A	Investment Amount	100,00,000	100,00,000
B	Post Expense Indicative Yield	7.50%	7.50%
C	Maturity Value after three years	124,22,969	124,22,969
D	Gain = C-A	24,22,969	24,22,969
E	Expected Annual CI Index	5.00%
F	Index Value for three years	1500000	0
G	Net Gain After Indexation (D-F)	9,22,969	24,22,969
H	Tax Payable @20%/ 30%	1,84,594	7,26,891
I	Total Income Cash Flow (D-H)	22,38,375	16,96,078
J	Maturity Value after three years	122,38,375	116,96,078
K	DIFFERENCE IN TOTAL CASH FLOW	5,42,297
	Additional return in % (K/A)	5.42%

As we can see from the table given above that the net return in FMPs can be as high as 5.4% compared to FDs when we expect the returns from both the instruments will be same although FMPs give little higher returns than FDs.

Are FMPs for Corporates/ Entities who are at higher tax bracket?

Well, FMPs are for everyone those who are looking a fix kind of returns. However the favorable tax structure makes it more attractive for those who comes under highest tax bracket. Corporates, Association of Persons and High Net worth Individuals. In fact, you can look upon FMPs as fixed deposits offered by mutual funds. Just like bank fixed deposits, Tax incidence differs as explained above.

As compared to other fixed income products like Bonds, Corporate Fixed Deposits FMPs fair better due to long term capital gain tax benefits as compared to interest which is fully taxable.

Also FMPs are quite safe since the underlying investments are either money market instruments or rated paper. Before investing, we can get an idea about the indicative yield from the scheme based on the current market scenario. The word used is “indicates” as against “assures” as SEBI rules do not allow mutual funds to assure returns. In any case, just like in the case of a bank fixed deposit, in an FMP too, investors would know beforehand what the return is going to be. 

And lastly, to choose an FMP, you should do just what you would do take a right advise through a professional Advisor.

The basic terms regarding debt investments

Like in food we need all the variants (i.e. Rotis, vegetables, pulses, salads etc.) so as to get all the necessary things for our developments similarly for investments also we should have all type of securities i.e. equity, debt, gold real estate so that we can get the best out of it. Although debt securities are viewed as the least interesting component of a portfolio, lacking the vitality of stocks and equity instruments. But it performs a useful function in a portfolio, and it would be sensible for investors to have basic understanding of them, in this post we are discussing the basics of debt securities.

Yield  

A Debenture / bond's coupon is the annual interest rate paid by the issuer of the security. It can be paid out by various frequency depending upon the terms of the security i.e. quarterly, semi-annually or annually. The coupon is always linked to a bond's face value.

Say you invest Rs 10,000 in a 5-year bond paying a coupon rate of 8% per year, semi-annually. In this case, you will receive 10 coupon payments of Rs 400 each over the tenure of the bond.

Bonds that don't make regular interest payments are called zero-coupon bonds, in which they don’t pay interest in between the tenure of the bonds. Investors buy such bonds at a discount to the face value of the bond and are paid the face value when the bond matures.

Say we invest Rs 10,000 Face Value bond having maturity after 5-year bond at a discounted value of Rs.7000. In this case the annualised yield comes to approximate 7.40%.

Companies also issue floating rate bonds where the interest rate is linked with some benchmark rates and it fluctuates as the benchmark rate moves.

Yield is different from the coupon rate.

Let’s say a bond has a face value of Rs 100 with and 9% coupon rate. This means that the investor will earn Rs 9 per annum on each bond he invests in.

Once the bond is issued, after that, it trades in the open market – meaning that its price will fluctuate each business day for its entire life depending upon various economic and market related factors. As interest rates in the economy rise and fall and demand for the bonds moves up and down, it will impact the price of the bond.

Let’s assume interest rates rise to 10%. Even so, the investor will continue to earn Rs 9. That is fixed and will not change. So to increase the yield to 10%, which is the current market rate of interest, the price of the bond will have to drop to Rs 90 {9/90= 10%}.

Now let’s say interest rates fall to 8%. Again, the investor will continue to earn Rs 9. This time the price of the bond will have to go up to Rs 111.29 (approx.) {9/111.29= 8%}.

This explains two aspects from the above examples.

·     One is that the yield is not fixed but fluctuates to changes in the interest rate.

·     Secondly, the price of the bond moves inversely to interest rates. It moves to maintain a level where it will attract buyers.

Yield to Maturity

The Yield to Maturity, or YTM, of a debt fund portfolio is the rate of return an investor could expect if all the securities in the portfolio are held until maturity. 

For instance, if a debt fund has a YTM of 9%, it means that if the portfolio remains constant until all the holdings mature, then the return to the investor would be 9% (annualised). This is generally applicable to Fixed Maturity Plans of Mutual funds.

However, in the practical world and especially for open ended mutual funds the YTM does not remain constant as the portfolios are actively managed by the fund manager.

YTM broadly indicates to the investor the kind of returns could be expected. But it is not a definite indicator since returns may vary due mark-to-market valuations or changes in the portfolio.

Modified Duration

Modified Duration, or MD is the number which can further elaborate the point that bond prices and interest rates are inversely related.

As explained earlier, if there is a rise in interest rates then there is a fall in the price of the bond. If there is a fall in interest rates, then the price of bond will rise.

MD is the change in the value a debt security in response to the change in interest rates. So let’s say the MD of the bond is 4. Then it indicates that the price of the bond will decrease by 4% with a 1% (100 basis point, or bps) increase in interest rates.

This provides a fair indication of a bond’s sensitivity to a change in interest rates. The higher the duration, the more volatility the bond exhibits with a change in interest rates.

When we consider the modified duration of a portfolio, It means that it takes into account all the debt instruments and will change with regard to the composition of the portfolio.

Credit Rating

All bonds/debentures are not equal and it is measured by the credit rating of the issuer company. There are five credit rating agencies approved by SEBI to rate the companies. The top rating for any security is AAA and it goes down to AA, A, BBB and so on. Generally the investors’ grade rating is upto BBB.

Higher the rating means stronger the issuer company which indicates lower the risk so the interest rate offered by the company will be lower as compared to the lower rated companies. Sovereign bonds issued by the government are generally called as risk free securities and considered as benchmark while comparing the risk return trade-off with other issuers.