Fixed Maturity Plans

 | July 11,2011 10:50 am IST

With the stock markets down, investors are looking for safer investment avenues that would give them good returns with a high degree of safety. One such avenue that is being strongly promoted by Mutual Fund houses and has been very popular with high net worth investors and corporate is fixed maturity plans (FMPs).

But the recent crunch in the liquidity which forced RBI to cut the interest rates with few more cuts has acted as a dampener for the hot cake FMPs.


What are FMPs?

Categorized under the Debt-Specialty, FMPs are close ended funds that invest in debt paper and were first launched in India by Kotak Mutual Fund in 2001. These funds have a pre-defined maturity period that ranges from 15 days to three years. By definition, these funds invest in debt instruments and money market instruments like commercial papers issued by companies and certificates of deposits issued by banks whose maturity coincides with that of the FMP. For instance, a one-year FMP will invest in bonds that will mature in one year. A fund house collects moneys from investors and uses it to buy one year papers. At maturity, issuers of bonds repay the money with interest to the fund house, which in turn pays investors (minus its charges).


The investment is locked in at a specified rate of return. This way, the investment managers can predict the probable return the scheme will earn when it matures with a high degree of certainty. This also immunises the scheme against interest rate fluctuations during the investment period. Hence, an investor who is invested in a FMP until its maturity is virtually assured of getting the projected returns.


Besides promising indicative returns at the start of the tenure, a factor that makes FMPs attractive is its tax efficiency. Short-term FMPs are subject to dividend distribution tax at the rate of 14.16 per cent, for dividend option. Otherwise, it is treated as short-term capital gains. In FMPs where the tenure is greater than a year, the investor has to pay long-term capital gains at the rate of 11.33 per cent without indexation and 22.66 per cent with indexation. There are double indexation benefits for tenures of over a year.


Are FMPs Safe?

As a product category, FMPs are very good instruments for parking your short-term surpluses, provided prudent investment choices are made by the fund managers.


However, FMPs carry a higher degree of risk as compared to a fixed deposit or any other debt instruments. FMPs are not the risk-free avenues they are made out to be. This is because they invest in commercial papers issued by companies, which is an unsecured debt. In bad times, some companies, with whom the asset management company places the funds, could default on their commitments. This could put the principal amount at risk. Hence, the degree of risk in an FMP is essentially dependant on the ability of the investment manager. A smart manager will choose very high quality instruments where the possibility of default is remote.

Causes for Current Crisis in FMPs

The disclosure norms in all mutual fund schemes in India are stringent enough to protect the investors. However, SEBI has not made mandatory for AMCs to disclose the portfolio and details of underlying securities while selling an FMP. AMCs have taken advantage of this fact.


To lure more investors with higher indicative yields and to boast of higher AUMs, some AMCs have resorted to malpractices like allowing mismatches in maturity period(between FMPs and their underlying securities) and have also compromised on the credit quality of securities these FMPs invest in.


Maturity Mismatch – With growing interest of retail and corporate investors in FMPs and the avalanche of funds that followed, a few fund houses started investing in papers whose maturity period was different from that of the FMP. Say, for instance, a three-month FMP invested in one-year paper. (A one-year paper will give one percentage point higher yield that a three-month paper). This is known as maturity mismatch. By doing so, an AMC is taking a call on one, liquidity. At the time of redemption of the three-month FMP or pre-maturity redemption, the mutual fund house could be hard put to find the funds for paying off the investors because the fund has invested in higher-maturity securities. And two, the AMC also courts interest-rate risk. If in the interim, interest rates rise, the value of longer-duration papers would decline. If, under redemption pressures, the fund house is forced to sell off the bond before the maturity, it will incur a loss.


Compromise on Credit Quality - To offer higher yields, AMCs also started compromising on the credit quality of the underlying debt paper they invested in. Real estate firms and NBFCs, which are starved for liquidity in the current cash-crunch, offered to pay higher interest rates to AMCs.


However, the inability of the some of these borrowers to live up to their repayment commitments invited trouble for some AMCs. In fact, real estate companies have offered interest rates as high as 22-24 per cent on debt raised from mutual funds.


In the recent liquidity crunch, when the corporate and HNIs including FIIs started withdrawing money swiftly, the maturity mismatch and compromise on credit quality cost some fund houses and showed their NAVs in negative in comparison with par value. The RBI in introduced a special window of Rs 20,000 crore repo facility for a period till further notice to help these funds bridge the gap between the redemption requests and the actual sale of the underlying assets, the borrowing from the repo markets would increase MF’s liability and make NAVs decline more. The SEBI also put cap on the redemption before the redemption date. Now, FMPs’ investors can’t redeem the investments before the maturity date.


Strengthen Regulation…

With few regulations, FMPs can work better. The most important, strict portfolio disclosure norms need to be put in place. SEBI should make it mandatory for a fund house to disclose its tentative portfolio to the investor. Mismatches in maturity between FMPs and their underlying securities should also be checked. Just publishing the name of the companies would not suffice rather AMCs should mention the maturity period of the underlying asset, so that an investor is aware of maturity mismatches, if any.


SEBI should also ensure that AMCs invest only in high-quality debt papers that have good credit rating and that too from established rating agencies. Lastly, bifurcated data on investments made by corporate and retail investors should be available.