Save Smart. Know the credit risk in FMPs

While investing in fixed maturity plans (FMPs), most financial planners often recommend FMPs with relatively higher indicative yields.

But if you are a conservative investor, FMPs with such higher yields may not suit your risk profile. Typically, relatively higher yields in FMPs imply higher exposure to lower-rated debt instruments. This can pose a threat to investors’ capital.

FMPs are closed-end mutual funds that you can invest in only during the new fund offer (NFO). As FMPs invest in debt instruments that have the same maturity as that of the fund, they are free from interest rate risk. But they carry credit risk, as there is a possibility of default by the debt-issuing company.

Lower-rated bonds

Currently, most FMPs are launched with a tenure of three years to take the benefit of indexation. FMPs invest predominantly in bonds and NCDs issued by companies. Given the longer tenure, funds find it difficult to shop for good rates within the highest-rated instruments of longer tenure.

They, thus, allocate some proportion of assets in AA and below rated debt papers to earn higher interest. Lower-rated papers carry higher coupon rates than higher-rated papers.

According to data from ACEMF, one-fourth of the 663 FMPs allocated their assets to relatively risky debt instruments, rated AA and below, towards the end of July 2018.

Downgrades and default

This hunt for higher yield is beginning to weigh on debt funds since instruments offering higher rates are mostly ones that carry a relatively higher probability of default by issuing companies.

Over the last three years, there have been a few instances of debt funds reporting losses, owing to downgrades or withdrawal of credit rating of the debt instruments they hold. In mid-2015, two debt schemes from JP Morgan MF were hit when Amtek Auto bonds were downgraded. The AMC then managed to sell the troubled debt papers at a 15 per cent loss, according to sources.

In May 2017, when ICRA downgraded the IDBI bonds, a few funds, including FMPs from ICICI Prudential, Baroda Pioneer, Aditya Birla Sunlife and Edelweiss took a beating.

While calculating NAV, mutual funds follow a valuation matrix for valuing illiquid corporate debt papers. Any rating downgrade leads to lowering of valuation of the bond which, in turn, results in drop in the NAV.

This drop in daily NAVs hurts open-ended schemes more than close-ended ones. Close-ended funds like FMPs are mostly passively managed funds investing in bonds that have the same maturity as that of the fund. But note that if a company defaults on its principal repayment, then the FMPs’ portfolio, to that extent, will be written off and will eventually impact the investment at the time of maturity.

Intended credit profile

The regulator SEBI has mandated AMCs not to disclose indicative yields of FMPs during NFO. Instead, AMCs are required to disclose the intended credit profile of the portfolio of the FMPs in the Scheme Information Document (SID or offer document) under the head ‘Section II – Information about the scheme’. The indicative allocation to the debt instruments with credit rating ranging from AAA/A+ to BBB are shown in the prescribed format.

This helps investors gauge the credit risk involved while investing in the FMP. Maximum exposure to bonds with AAA/A+ is considered the safest option.

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