Is a Mutual Fund FMP an Ideal Option?
Any individual who wants to invest money at a higher rate of return than fixed deposit can choose to invest in FMPs. These investments are riskier than fixed deposits but they have very low risk as compared to funds which invest in equity instruments
In India, fixed deposits are the most preferred way of parking one’s savings. As per a report published by the Securities and Exchange Board of India (SEBI), 95 per cent of Indian families invest in bank fixed deposits. Why is this so? The obvious reply is that fixed deposits (FDs) are considered to be one of the safest investment avenues that gives you an assured fixed rate of return. However, what is less known is that similar to bank fixed deposits, even debt mutual funds provide you an investment vehicle known as mutual fund fixed maturity plans (FMPs). Mutual fund FMPs are close-ended debt funds.
They share many characteristics of fixed deposits provided by banks. They are of a fixed tenure, ranging from one month to five years. The opportunity to invest in FMP is for a limited period. You can only invest between the launch and closing dates of the NFO. They cannot be bought and sold often, like open-ended debt funds. Fund managers of such funds invest only in debt instruments like non-convertible debentures of any company, government bonds, treasury bills, money market instruments, commercial papers and certificate of deposits, among others.
The fund manager invests in those securities that have similar maturity period as that of the FMP. So, if a FMP has maturity of three years, the fund manager would invest in the same maturity debt instrument as the FMP maturity period. Unlike other debt funds, the fund manager of FMP follows a buy and hold strategy. There is no frequent buying and selling of debt securities like other debt funds. This helps to keep the expense ratio of FMPs at lower level as compared to other debt funds.
Should you Invest in FMP?
Ideally speaking, any individual who wants to invest money at a higher rate of return than fixed deposit can choose to invest in FMPs. These investments are riskier than fixed deposits but they have very low risk as compared to funds which invest in equity instruments. As the nature of investment is debt, repayment of the investment would be compulsory for the organisation as well as the government, as compared to equity holders who are the last to receive returns from an organisation. Since these instruments mostly offer higher returns than bank FDs of similar duration, FMPs deliver higher returns than fixed deposits at slightly higher risk.
Returns you receive in FMPs do not fluctuate like other debt instruments with change in interest rate scenario or other economic changes that impact interest rate. Returns from a FMP are taxed as per the slab of the individual when earned in the short term i.e. less than 36 months. However, if invested for long term, there is a benefit of indexation and a flat rate of 20 per cent tax.
Benefits for Individuals in Higher Tax Slab
Individuals who have higher income can get greater post-tax returns by investing in FMPs. By investing in FMPs for a longer period of time the taxation levied is long-term capital gain with indexation benefit. Return from investment in fixed deposit is taxed according to the slab rate of the individual which will lead high net income individuals paying greater amount of taxation and lower post-tax returns. Tax becomes almost negligible with indexation benefit because of which FMPs are attractive for high income individuals who want to invest a greater amount.
Now let us study some of the key advantages and disadvantages of investing in FMPs:
1. Higher Rewards for Lower Risks :
Though FMPs fluctuate in value with certain changes such as financial performance of the corporation or entity, etc., these fluctuations tend to be less volatile as compared to the swings in the equity markets while providing a higher return than FDs. Hence FMPs provide a better return with a lower risk than equity but higher returns as compared to fixed deposits. Nonetheless, in past we have seen how investment by some FMPs in some corporates resulted in lower returns and liquidity issues. Therefore, you should know there is risk in investing in FMPs.
2. Close-Ended :
Though this is a disadvantage from the liquidity perspective, these funds do not allow any capital inflows or outflows during the period of the fund, allowing the fund management to focus on the money received rather than increasing the fund size. This limits the risk for the old investors as the manager is left with a fixed amount to invest.
3. Lower Taxation :
Though FDs provide fixed returns, these returns are taxable as per the tax slabs of the investor. In long-term funds these returns are taxed a flat rate of 20 per cent after indexation benefits, resulting in lower taxations for individuals with higher income. Hence, FMPs offer higher post-tax returns compared to fixed deposits.
1. Liquidity :
These debt funds are close-ended and just like they do not allow any new investors they do not allow investors to withdraw their funds before the maturity of the fund period. You can try to sell your FMP from your demat account on the stock exchange before maturity but the liquidity of these instruments in the exchange is very low i.e. you may not be able to find a buyer. Hence, this fund can only be useful for those who can afford to keep their money locked and never look back until the end of the period. In case the investor wants to keep the money liquid, these funds are not a good option.
2. Fluctuating Returns
The returns of these funds are estimated and not as per the specified amount in the fund brochure. Unlike traditional FDs, these funds are prone to fluctuations in the markets and the performance of the organisation issuing these instruments.
3. Narrower Range of Instruments
Due to the specific period of such funds, the fund manager has a limited choice of instruments to choose from as he must invest in such segments which are in parallel timeframe to the period of the fund, thus removing a lot of options from the available investments.
FMPs have historically given better returns than fixed deposits and therefore can be considered by high income individuals who do not have much liquidity requirement for the tenure of investment in FMPs. These are also suitable in a situation when the interest rate is likely to fall as it will help to lock-in higher rates. In the current scenario, when interest rate is low, FMPs can be a good alternative to FDs with investment horizon of more than three years.