06 December, 2010

The case for FMPs...

Look at the tax angle and the returns are often higher than the more popular debt options

Several Fixed Maturity Plans (FMPs) have been coming into the market for over three months. Let us examine what these are and why they may be useful.

FMPs typically are debt-oriented products, comprising bank certificate of deposits (CDs), commercial papers (CPs) issued by companies, structured obligations, debentures and bonds, pass-through certificates and so on. The duration can be a month to five years. As the name suggests, these are closed-ended products, comparable to bank fixed deposits (FDs) most retail investors opt for. They are sometimes called by slightly different names - Fixed Tenure Fund, Fixed Horizon Fund. The monthly and quarterly FMPs are also called interval funds.

FMPs are yet to become as popular as FDs with investors. However, there are some significant advantages of investing in these. Firstly, FMPs come in all kinds of tenures, from a month to five years. FDs can match this to a great extent, though the choice of tenures with FMPs is much more. Second, as opposed to FDs, the risk profile would be lower here. This is because FDs are with one institution and, so, pose a risk. If it is with a company instead of a bank, the risk is a bit higher. Instead, FMPs invest in a varied mix of CPs, CDs, debentures, which brings down the risk profile of the portfolio. Also, the fund manager ensures the maturity profile is more or less matched with the FMP's tenure and, hence, interest rate risk is almost eliminated. In most FMPs, a small proportion is invested in equity (for instance, Franklin Templeton Fixed Tenure Series). Clearly, the investor needs to understand what the FMP asset allocation would be and then invest.

Third and important, FMPs can offer a higher post-tax return as compared to FDs. For those in the highest tax bracket, FMPs will be very advantageous. In case of FMPs, the dividends distributed by the fund house are taxed in the latter's hands itself. Dividend Distribution Tax is 14.16 per cent now. The dividend received in the hands of the investor are not taxable. Hence, the investor effectively pays only 14.16 per cent tax, as opposed to the 31 per cent he would have paid for interest received from FDs, as they are treated as income and clubbed accordingly. Also, one could take advantage of indexation for FMPs of longer durations.

Indexation works like this: If one invests Rs100 today and takes it out after a year, getting Rs108, the profit is Rs 8. However, the value of Rs 100 last year is not the same today, as inflation has eroded the value. If inflation is at 7 per cent, then Rs 100 last year would be equivalent to Rs 107 today. Then, rightfully, only Rs 1 is the profit. The indexation principle takes this into account. The cost inflation index to be used for such calculations is published by the income tax department.

The tax on short-term capital gains (for investments of less than 12 months duration) for an individual is as in the applicable income tax slab rate. Long-term capital gains would be taxed at 10 per cent without indexation or 20 per cent with indexation. Hence, one can calculate and pay tax on whichever turns out to be less. In this example, a 20 per cent tax on a rupee is 20 paise; a 10 per cent tax without indexation on long-term capital gains works out to 80 paise. Hence, the 20 per cent with indexation is more beneficial for the investor. In this example, the net return for the investor is 7.8 per cent. Had the same investor invested in an FD yielding eight per cent and assuming he is in the highest tax slab, he would have to pay 31 per cent as tax.The return would then be only 5.52 per cent. A major difference, which is why FMP is a good investment option.

Coming to liquidity, previously fund houses used to accept premature redemptions, albeit with an exit load. Now, that has been stopped and FMPs are listed on the stock market. An investor who wants to redeem can directly sell on the stock market. However, this portion of the market is not liquid and may pose difficulty if a person requires money before maturity. Hence, invest money only when sure of staying invested till maturity.

It should also be clear to the investor that for tenures less than a year, a dividend distribution option may be better, as the tax incidence would be 14.16 per cent (paid by the MF), instead of their slab rate. The investor would be better off paying tax and be in the growth option, if their slab rate is the first slab, that is,10 per cent. For tenures more than a year, taking advantage of indexation would clearly be a better option, for most tax payers.

FMPs seem to be the best kept secret, with not too many knowing about the potential for much higher post-tax returns, without taking much higher risks. FMPs are a viable alternative to FDs and other debt investment options. Investors would do well to harness the potential for higher returns these offer.

Published in Business Standard on 7/11/2010

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