Mutual Funds

Should you invest in fixed maturity plans?

Dhuraivel Gunasekaran | Updated on March 23, 2019 Published on March 23, 2019

While you can reduce your tax outgo on capital gains, take note of the credit risk

Flummoxed by the slew of fixed maturity plans (FMPs) being launched by various fund houses at the fag end of the financial year? Mutual funds usually launch a higher number of FMPs in March in a bid to lure investors with the ‘double indexation benefit’ pitch that can reduce the tax outgo considerably. Should you consider these funds before the financial year closes?

FMPs are close-ended mutual funds that one can invest in only during a new fund offer (NFO). As FMPs invest in debt instruments that have the same maturity as the fund, they are free from interest-rate risks. For instance, an FMP with a three-year maturity invests predominantly in debt securities that mature in, or with the residual maturity of, around three years.

But they do carry credit risk, as there is a possibility of default by the debt-issuing company.

Generally, the returns from FMPs are equivalent to the yields of securities with similar maturities prevailing on the date of the investment. Currently, the yields on government securities, AAA, AA and A rated corporate bonds are in the 7.5-10 per cent range. Hence, annual returns from the ongoing FMP NFOs with a three- year maturity could be 8-9 per cent.

Given the decent bond yields, investors can consider parking some money in these newly launched FMPs.

Added attraction

What makes FMPs more attractive is the extra tax savings on account of indexation benefit.

As per the current tax structure, sale of units of non-equity funds, including FMPs, within 36 months from the date of allotment attracts short-term capital gains tax. This is levied as per the investors’ tax bracket. On the other hand, long-term capital gains tax (LTCG) is applicable if the units of FMPs are redeemed after 36 months, which is charged at 20 per cent with indexation.

The indexation benefit allows an investor to index her investment to inflation, which minimises the tax outgo substantially. Indexation essentially adjusts the purchase price of assets with inflation when computing the gain. Cost Inflation Index (CII) is used to index the cost of purchase. Every year, the Central Board of Direct Taxes publishes the CII value applicable for the financial year.

Hence, FMPs launched with three years maturity qualify for LTCG.

For instance, suppose you had invested ₹1 lakh in an FMP in FY16 and sold it at ₹1.3 lakh in FY19. The CCI value in FY16 and FY19 are 254 and 280, respectively. So, the CII multiple is 1.1 (280/254=1.1), which is multiplied with the cost price.

From the above example, your cost of acquisition will be ₹1.1 lakh. The effective gains will be ₹20,000 (₹1.3 lakh less ₹1.1 lakh), on which you will have to pay 20 per cent tax. If the indexation benefit were not available, you would have had to cough up 20 per cent tax on ₹30,000 instead. That’s a tax saving of ₹2,000.

The savings can be substantial if investments are larger. Hence, FMPs are usually a big hit with institutional investors.

For retail investors, too, the double indexation benefit (if invested towards the end of the financial year), is a big draw. How does this work?

Fund houses usually launch FMPs maturing little over three years, in March. This helps investors to take advantage of indexation by investing in one financial year and then selling in the fourth financial year since then.

For instance, the FMP NFO of Aditya Birla Sun Life Fixed Term - Series SL (1120 days)’ closes for subscription on March 26, and its date of inception is March 27. The FMP will mature on April 19, 2022. So, the investment is made in FY19 and sold in FY23. Here, the holding period is treated as four years and the investment will be eligible for the indexation benefit for four years. This will further reduce the tax outgo.

While good returns and tax benefit make FMPs an attractive option for investors, the higher credit risk in some of these funds needs watching.

Many FMPs allocate a notable proportion of their assets in AA and below-rated debt papers to earn higher interest. Lower-rated papers carry higher coupon rates than higher-rated papers. This hunt for higher yield pegs up the risk quotient in these funds.

In recent times, defaults and downgrades of credit rating of debt instruments have impacted many debt funds. If a company issuing the bond defaults on its dues, the FMPs’ portfolio will be written off to that extent, impacting the value of your investment at the time of maturity.

Hence, if you are a conservative investor, consider FMPs with relatively higher rated bonds in their portfolio.

Fund houses are required to disclose the intended credit profile of the FMPs’ portfolio in the Scheme Information Document (SID, or offer document). The indicative allocation to the debt instruments with credit rating ranging from AAA/A+ to BBB are shown in a prescribed format. This can help you gauge the credit risk while investing in an FMP. Go with FMPs with a higher allocation of bonds with AAA/A+ rating.

Checking the portfolio on an ongoing basis is also essential. Inter-scheme transfer allows the transfer of assets from one scheme to another within the fund house. Many a times, fund houses transfer riskier assets from open-ended schemes (as a short-term risk-mitigating tool) to FMPs that are close-ended schemes.

Liquidity a concern

Also remember, when the market is volatile, exiting FMPs will be difficult. FMPs are close-ended funds and no premature redemption is available. While these units are listed and traded in the secondary market, poor liquidity is a huge deterrent for investors looking to exit in a hurry. Investors not wanting to lock in their money for a long term can consider investing in open-ended debt funds instead and claim the indexation benefit.

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