A complete guide to Fixed Maturity Plans (FMP)

FMPWhenever, we think of fixed returns, the first investment avenue that comes to our mind is bank fixed deposit (FD). We often tend to follow the traditional investment avenues as these are considered safe and tend to provide fixed returns. But Fixed Maturity Plans (FMPs) is another alternate investment avenue which should be considered before making an investment decision towards your debt portfolio.

What is Fixed Maturity Plans?

Fixed maturity plans are type of debt fund where the investment portfolio is closely aligned to the maturity of the scheme. AMCs tend to structure the scheme around pre-identified investments. Further, like close-ended schemes, they do not accept money post NFO (New Fund Offer). The characteristic of FMP is such that they are passively managed by the fund manager.

FMPs are somewhat different than a fixed deposit in a bank. FMPs are debt schemes, where the corpus is invested in fixed-income securities. Even though, FMPs may have an exposure to high quality debt securities, FMP’s returns are not ‘guaranteed’. Predominantly, because the fund house knows only the interest rate of the securities that the FMP will earn on its investments.

How do they work?

The basic objective of FMPs is to generate steady returns over a fixed tenure, thus shielding investors from interest rate fluctuations. FMPs achieve this by investing in a portfolio of debt securities [predominantly certificate of deposits (CDs) and commercial papers (CPs)] whose maturity or tenure matches with that of the scheme. These securities mature on or before the end of the FMP term.

For example, if the FMP is for 12 months, the fund manager will invest in instruments with a maturity of 12 months or less. Since FMPs are closed ended and investors cannot redeem units with the mutual fund during the FMP tenure, the fund manager need not sell any part of the portfolio (to provide for redemption) during this tenure thus locking the yield of the portfolio. This also mitigates the risk of loss on premature sale of securities and lowers the interest rate risk. However, the investors have the option to redeem the units of FMPs on the stock exchanges, where the FMPs are listed, and hence may impact the portfolio’s return to the extent of redemptions received.   Also, the fund manager at his discretion may churn the portfolio of the FMP in order to get a better yield.

FMPs, however, are not allowed to provide ‘indicative yields’ to investors like in the case of FDs, where interest rates are pre-defined. However, in a rising interest rate environment (as is currently prevailing), FMPs will inherently capture this trend.

Where do they invest?

FMPs have exposure to high quality bonds (generally AAA/AA rated). As FMP being a debt fund, the portfolio is more tilted towards fixed income securities like certificate of deposits (CDs), commercial papers (CPs), Corporate Debt, floating rate instruments, pass through certificates (PTC), money market securities, government securities etc. The exposure across different debt instruments makes it more attractive and reduces the portfolio risk.

The FMP comes with different maturities like 1 month, 3 months, 6 months, 1 year, 3 years or even more. The different maturities provide an option to investors to choose an FMP as per their investment horizon.

Tax Advantage

Fixed Maturity Plans scores high on tax advantage when they are compared to similar instruments like Fixed Deposits (FDs). In FDs the interest earned is added to the investor’s income and taxed at individual personal income tax rate. Interest from Fixed Deposits is categorized as ‘Income from Other Sources’ under the Income Tax laws. In the case of FMP, the tax implication depends upon the investment option chosen – Dividend or Growth.

Which option should you choose?

  1. Dividend Option: Dividends in FMPs are tax free in hands of investors. However, Mutual Fund companies have to pay a Dividend Distribution Tax (DDT) of 25% plus surcharge and cess for Individuals and HUFs (28.325%) and 30% plus surcharge and cess for others (33.99%) before distributing it to investors.
  2. Growth Option: If any investor opts for Growth option, he is subject to Capital Gains Tax. Short Term Capital Gains (if units are held for 12 months or less) are taxed as per the Tax Slab Rate. For Long Term Capital Gains (if units are held for more than 12 months) are taxed at 10% without indexation or 20% with indexation. The indexation benefit inflates the cost of purchase lowering long term gains tax liability, which is not the case of FDs

The length of the holding period matters, especially when one has to decide between growth and dividend options. Investors can go for the growth option if the holding period is more than a year and for the dividend option if the holding period is less than a year.

Fixed Deposits (assumed for investor at highest tax bracket)FMP Without Indexation (Growth Option)FMP With Indexation (Growth Option)
Amount Invested100,000100,000100,000
Tenor in Days500500500
Assumed Returns9.50%9.50%9.50%
Maturity Value113,014113,014113,014
Interest Gains13,01413,01413,014
Indexed Costs*NilNil108,535
Indexation Gain / LossNil13,0144,479
Tax Rate30.90%10,30%20,60%
Tax on Interest Income4,021
Tax on Capital Gains1,340923
Post Tax Income8,99311,67412,091
Post Tax Return (Simple Interest)** (rounded off to 1 digit)6.6%8.5%8.8%

* Cost of Inflation Index (CII) in 2011-12 was 785 and CII in 2012-13 is 852. Source: Central Board of Direct Taxes (CBDT)

DOUBLE INDEXATION BENEFITS

Double indexation simply means getting the benefit of two years of indexation when the holding period for investments has been substantially less than two years.



Concept of Double Indexation

  1. If Mr. ABC had bought 10 units of mutual fund for Rs. 10,000 on 1st April 2012 and sold them for 11,000 on 1st April 2013. (Holding period- 1 year).
  2. If Mr. ABC had bought 10 units of mutual fund for Rs. 10,000 on 31st March 2012 and sold them for 11,000 on 1st April 2013. (Holding period- 1 year and 1 day)

In the two examples given above, the information is same except the year of purchase, which differs by just one day.The difference in one day changes the financial year of purchase for Mr. ABC, which changes the CII numbers to be used for indexation.

Case A: Single Indexation

ParticularsAmount (Rs.)
Cost of Purchase10,000
CII- year of purchase (2011-12)*785
CII-year of sale (2012-13)*852
Adjusted cost of purchase10,854
Taxable return – with indexation (Rs.11,000 – Rs,10,854)146

*Source: Central Board of Direct Taxes (CBDT)

Case B: Double Indexation

ParticularsAmount (Rs.)
Cost of Purchase10,000
CII- year of purchase (2010-11)*711
CII-year of sale (2012-13)*852
Adjusted cost of purchase11,983
Taxable return – with indexation (Rs.11,000 – Rs.11,983)(983)

*Source: Central Board of Direct Taxes (CBDT)
Here is a small comparison between Fixed Deposits & FMP with Double Indexation Benefits:

Fixed Deposits (assumed for investor at highest tax bracket)FMP With Double Indexation
Amount Invested100,000100,000
Tenor in Days500500
Assumed Returns9.50%9.50%
Maturity Value113,014113,014
Interest Gains13,01413,014
Indexed Costs*Nil119,831
Indexation Gain/LossNil(6817)
Tax on Interest Income4,021
Tax on Capital Gains(1404)#
Post Tax Income8,99313,014
Post Tax Return (Simple Interest)6.56%9.50%

* CII in 2010-11 was 711 and CII in 2012-13 is 852. Source: Central Board of Direct Taxes (CBDT).
#Investors can set of Long Term Losses with Long Term Gains

Investors should be aware that the fiscal rules/tax laws may change and there can be no guarantee that the current tax position may continue indefinitely. In view of the individual nature of tax consequences, each investor is advised to consult his/her professional tax advisor.

Factors Affecting FMP

While FMP offer several advantages over other fixed income products when interest rates are rising, there are still certain factors that investors should keep in mind before taking the plunge. Here are a few of them.

Check Indicative portfolio:  If the indicative portfolio shows the portfolio will invest majority of the corpus in bank certificates of deposits (CDs), then the portfolio may have lower risks compared to FMP’s which invest predominantly in Commercial Papers (CPs). Seen from the other side, having Commercial Papers in the portfolio may mean slightly higher rates. So as an investor before investing in an FMP you should have a clear idea about the risks you are willing to take.

Credit rating of the securities:  You should also check the scheme’s offer document for the minimum credit rating of the securities the fund intends to invest into. The investors should also note that the higher the credit ratings of their securities, the lower the returns would be for the FMPs and vise versa. However lower credit rating securities have higher credit risks; hence investor should keep in mind the same.

Expense Ratio of the scheme – Investors should select a scheme which has a reasonable expense ratio as per the tenor of the FMP, as higher expense ratio reduces the overall yield on the FMP.

Maturity of the Scheme: Some of the FMPs launched between January and March every year offer double-indexation benefit. Double [email protected] helps reducing long term capital gains thereby reducing overall tax liability.

Growth or Dividend Option – The length of the holding period matters, especially when one has to decide between growth and dividend options. Investors can go for the growth option if the holding period is more than a year and for the dividend option if the holding period is less than a year.

Liquidity:  Sebi rules mandate that all FMPs should be listed on the exchange, however liquidity in these instruments on stock exchanges is low. So as an investor if you are investing in an FMP, invest only those funds that you don’t need till the maturity of the fund, as option to redeem with fund house is not available until maturity.

Source: Mirae Asset Management Company

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