Nov 28, 2008

4 Considerations to Know Before Investing in FMPs

NO doubt, fixed maturity plans (FMPs) are able to generate higher returns which coupled with favorable tax treatment makes them attractive in comparison to fixed deposits. However, there are some important considerations to remember before you plan to invest in them.

Here are four such special considerations to know before rushing in to invest in them:

1. Exit before maturity
In case of FMPs liquidity comes with a price. There is no entry loads but withdrawals prior to maturity are subject to high exit loads. Thus, premature withdrawal can nullify any gains made by investing in the schemes.

Before investing, insure that you intend to stay invested for the entire duration of the scheme. Choose a fund with a tenor which matches your investment horizon.

UPDATE: As now listing is mandatory, the only exit route available is through stock-exchange. As a result, liquidity of FMPs have suffered due to low trading volumes.

2. Dividend vs. growth option
If you are investing for less than one year you should go for dividend option. But remember that DDT is indirectly borne by the unit holder. It is beneficial for those chargeable at higher rates but adversely affects those who don’t have taxable income or fall in the lowest tax bracket.

Conversely, for more than a year one should invariably opt for growth option because even the 10% (plus surcharge) rate without indexation applicable for LTCGs is better than the DDT rate.

Further, if you are investing at the end of the financial year, it is better to opt for FMPs with tenure of 370-400 days to cover two financial year ends so that you can avail double indexation benefit. In other words, if you invest, say, in the month of February 2009 or March 2009, go for FMPs maturing in the April 2010 to get the maximum tax benefit.

3. Returns not assured
Remember the yield is always indicative and not assured. There always remains a chance of actual returns deviating from the indicative yield. There is a few days gap between collections and investments and in between there can be changes in the interest rates. Besides, there can be variability of returns in case of any mismatch between the maturity profile of the FMP and that of its underlying investments.

UPDATE: Sebi has banned FMPs from offering indicative yields.

Furthermore, they are open to the risk of premature withdrawals. The major flaw is that these schemes are not strictly close ended because limited liquidity is provided by way of early exit option rather than through listing at the stock exchanges. In case of large scale withdrawals, these funds have to sell there most liquid investments and even borrow at high rates of interest leading to a fall in there NAVs leaving the remaining investors poorer.

However, SEBI which is undertaking a structural review of the FMPs is contemplating either to increase the exit loads or putting an end to early exit option so as to plug the loophole and make FMPs truly close-ended schemes. AMFI (Association of Mutual Funds in India) has even suggested barring them from announcing indicative portfolio and indicative yields due to large scale deviations between indicative and actual portfolios.

For update regarding listing, please click here

4. Default risk
Although FMPs invest mostly in high grade corporate papers, but there is always a slight credit risk present (risk of default in principal and/or interest payments).

Although till now, there has not been any default, but in the year 2008 large scale redemptions (despite hefty exit loads) by corporates were due to doubts about the investments by the FMPs in the low grade paper. Based on investigations SEBI had also concluded that FMPs have significant exposure to volatile sectors such as realty and NBFCs.

Also see:
1. Top Ten FAQs on FMPs

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