Fixed Maturity Plans (FMPs) are finally being recognised as an important part of one's portfolio. And there are good reasons for their sudden popularity. They allow the investors to have a fixed time frame in mind.



Another major plus is that they offer an indicative return, which are mostly met. And, they are cheap in comparison to mutual funds. That is, their expense ratios tend to be very low and they do not charge any entry or exit load (if you stay on for the entire tenure).

But we all know that none of these features are novel. So why are investors drawn to FMPs now though they have been in existence for years? Simply because the high interest rates are going up consistently.

And for those who think we are making a big deal out of nothing, here are a few statistics to drive home the point. In calendar year 2006, FMPs garnered Rs 89,647 crore. In the first four months of 2007, the collections have already touched Rs 71,607 crore. But if interest rates are wooing investors, then why not a good ol? bank fixed deposit or a debt fund?

Why not a debt fund?

After all, the portfolios of both would be identical: bonds, corporate debt, government securities, fixed deposits and various money market instruments.

The similarity ends there Unlike debt funds, FMPs have a fixed maturity that can start as low as 15 days and go on to 12, 13 and 14 months. You will even get some with longer maturities but they are more an exception than the norm.

For investors who want to park money for short periods of time, this one makes a perfect fit. What's more, it makes life easier for the fund manager.

All that he has to do is invest in instruments that have the same maturity period as that of the scheme. So a 10-month FMP’s portfolio will have instruments that have a 10-month maturity while a three-month FMP will have instruments of a three-month maturity. Accordingly, he can state his indicative return. Then sit back and wait for maturity.

Investors are now certain of the tenure and also have an indicative return, both of which are not possible in an open-ended debt fund.

Now irrespective in which way interest rates moves, the investor (and the fund manager) need not be concerned. On maturity, the fund manager will dispose the instruments and the investors will get the return indicated.

Because FMPs are more passively managed than regular debt funds, the investor insulates himself against loss on the investment by staying put till maturity.

The bond fund manager does not have it so easy. He will not only have to deal with flows into and out of his fund, but will also have to contend with interest rate fluctuations in the economy. But if he gets his calls right, he could make a neat packet.

Here’s how it goes. Bond prices move in the opposite direction of interest rates. When interest rates rise, bond prices fall and when interest rates fall, bond prices rise.

So if interest rates increase, the prices of bonds within the portfolio will decrease. But, if interest rates fall, then the value of the portfolio goes up. And, the fund manager can capitalise on this by selling his bonds at a profit.

Or a bank deposit?

On the face of it, a bank deposit scores simply because you do not have to bother about an indicative return. In a bank deposit you know exactly how much you are going to get and when.

This argument would have held ground a few years back when Section 80L of the Income Tax Act was in force. When Finance Minister P Chidambaram did away with it in 2005, the interest earned on bank deposits became completely taxable.

When you take the tax on interest earned into account, you get a completely different picture. If you opt for a short-term FMP, you will benefit because the dividend distribution tax, which is paid by the mutual fund, is lesser than the income tax you pay on your gain in the bank fixed deposit. Also, the short-term returns on a FMP are higher than those on bank deposits.

So even though a bank deposit and a FMP may each offer the same interest rate, you will score with a FMP. In fact, you could even do better with a FMP that has a lower return than the fixed deposit.

If you opt for a 13-month or longer FMP, the interest rates may tally with what banks are offering. But you will still benefit with a FMP because you can claim indexation benefits.

Indexation is the process by which inflation is taken into account when calculating your return. This lowers the tax incidence. You can either pay 20 per cent with indexation or 10 per cent without indexation. A far cry from what you would pay on the returns from your bank fixed deposit.

With the tax benefits and interest rates at these current levels, a Fixed Maturity Plan does seem inviting. In fact, there seems to be no logical explanation why anyone would still opt for a bank deposit.

But, you can firmly state that it is a good product for you only once you understand every single risk involved.

Article Publish by: www.investmentbankingcentral.com