FMP – the newest investment tools

Fixed maturity plans (FMPs) are in the news, all for wrong reasons. It is one of the newest investment tools to catch the fancy of investors-both risk takers and risk averse alike for sometime now. As for the risk favoring stock market investors, it was a great avenue to park their funds for a short period until they could take a call on the future course of the market. And the risk-averse devotees of fixed deposits found it a better investment, as it offered better yields and a much more tax efficient tool.

However, of late, people have started doubting the very concept of FMPs, as there were reports of over exposure to real estate funds. It was rumored that some of these real estate companies couldn’t pay the interest on time because of the depressed state of affairs in the sector. Further, there were reports that even high net worth and institutional investors were planning to get out of these schemes. In short, is it time to panic?

Those who are unfamiliar with the theme of FMPs, here is a short lesson. FMPs are schemes floated by mutual funds and they work almost like a bank fixed deposit. They come for different maturities like three months, six months, one and two years and rarely for three years. These schemes used to invest in instruments of matching maturity and this helped them to give an indicative portfolio and returns to investors at the time of subscription. Further FMPs with maturity over one year also enjoyed tax advantage over fixed deposit. This is because the difference in incidence of tax on FMPs.

Investors in debt funds or non-equity funds like FMPs, balanced funds, Monthly Income Plans and so on have an option to pay tax on long term capital gains at 10% without applying indexation or 20% after applying indexation to the cost of acquisition. Under the Income Tax Act, the government of India announces the Cost Inflation Index (CII) for each financial year. The index cost of acquisition of a long term capital asset, bought after April11981 is arrived at by multiplying the actual cost by CII of the financial year of sale of the asset and dividing the CII of the financial year of purchase of the asset.

To illustrate, suppose an investor has invested Rs1lakh in an FMP in March 2007 for a period of 13 months. That means the FMP would mature in April 2008. Assuming a yield of 10% per year, Rs1lakh would become Rs110,833 under the growth option after the 13-month period and the investor would receive the amount in April 2008. That means the investor has pocketed a long-term capital gains of Rs10,833. If the investor opts for long-term capital gains with double indexation benefit, the yield would work out to 9.825% or net gains of around Rs10,644. Alternatively, if the investor opts for long term capital gains without indexation benefit, the yield works out to be 8.97% or net gains of Rs 9,717. Remember, the yield on a bank fixed deposit would be significantly less than this, especially if you are in the higher tax bracket.

Now coming back to our earlier question of whether these tax efficient tools have become too dangerous to handle? Mr.X started investing in FMPs two years ago and thought they were a good bet. He was a retired private sector executive. However when X heard news of defaults by real estate firms, he really got scared and did’nt want to lose money in any fancy scheme. No wonder, he is opting for the “safer” fixed deposit from next year. Is it an emerging trend?

According to financial advisors, only a few investors seem to vary about investing in FMPs. A certified financial planner says if an investor wants a higher rate of return from debt investment, he does not have much of a choice. He has to invest in floating rate funds, liquid schemes or FMPs. It is still a good option according to a wealth management firm. If some funds tried to earn a higher return through aggressive investment does not mean the idea has failed. He adds that funds which invest aggressively in corporate paper may indicate a possibility of higher returns, but they are a risky proposition.