By number of funds as well as money invested, one of the most important type of mutual fund in India is something that is generally called a Fixed Maturity Plan (FMP). Of the 1920 mutual funds that are currently available, no fewer than 805 are FMPs, as they are known. And of the Rs 5.61 lakh crore that is invested in Indian mutual funds today, 68,000 crore is in FMPs.
FMPs are generally used by companies and large investors as an alternative to bank fixed deposits. In general, these funds resemble FDs more than they do other mutual funds. These are closed-end funds, meaning that one can only enter them when they are launched and exit them when their pre-stated term is over. Actually, one can exit them earlier, but generally after paying a load that is high enough to be a serious discouragement. More importantly, fund companies offer an 'indicative return' for FMPs. Unlike other types of mutual funds, FMPs are run in such a way that this indicative return actually has some meaning.
FMPs invest in debt instruments with the intent of holding them to maturity. This means that regardless of any ups and downs in the market value of the investments, the final earnings are predictable. Therefore, the indicative returns that FMPs provide to investors reflect the reality.
One obvious question is why investors should prefer FMPs to bank deposits. The reason is mostly to do with tax efficiency. When you put money in a fixed deposit, the interest gets added to your income. In FMPs longer than a year, if you elect to take all your gains as capital appreciation, the taxation is merely 10% with indexation benefit or 20% with indexation. That's generally quite a saving from the tax rate, which either individuals or companies would pay on the interest earned from a bank deposit.
Even for investments less than a year, there's a tax advantage if the investor takes the option of receiving the gains in the form of dividends. In this case, individual investors will get taxed at 12.5% of the returns and corporates will get taxed at 20%.
This is the dividend distribution tax that is deducted by the fund company. Once this is paid, no further taxation applies to the income. Although this is obviously not as much of a tax advantage as the long-term capital gains option, it's still a lot lower than the full tax payable on bank deposits.
The only question that remains is if they are as safe as bank deposits. In theory, they aren't. Like any other mutual funds (and unlike banks), you could lose all your money in an FMP. In practice, FMPs have been predictable and safe.
However, to enhance the overall yield, FMPs may assume high credit risk and run the risk of default. Nowadays, the increasingly tight liquidity and credit situation could mean that some of the companies in which FMPs invest could be sailing closer to the edge than earlier. There's plenty of talk about how some real estate companies are facing tough times. If an FMP has invested in such a company's debt, the chances of an FMP returning less than the indicated yield or even turning in a capital loss cannot be ruled out completely.
Generally speaking, FMPs invest in high quality instruments, which have been rated by at least one credit rating agency. In case of investment in unrated papers, prior approval of the board of directors of the AMC or the Trustee has to be obtained. All things considered, even though FMPs are generally seen as something that only companies invest in, there's no reason why individuals should not use them as more tax-efficient fixed deposits.
The author is CEO, Value Research
This is a copy from The financial express.
