Though slightly riskier than FDs, fixed maturity plans offer better returns due to different tax treatment on gains
FIXED maturity plans (FMPs) are back in vogue. Since September, more than 100 such schemes have been launched which have managed to collect 24,518 crore, according to Value Research. An environment of rising interest rates has helped increase their popularity, especially among high net worth individuals. Also, the fact that interest on fixed deposits (FDs) is taxable makes investing in an FMP a better bet than investing in FDs. Given these reasons even smaller retail investors should be looking at FMPs
What Are FMPs?:
These are schemes with a fixed maturity date i.e., they run for a fixed period of time. This period could range from 15 days to as long as two years or more. Like in an FD, when the period comes to an end, the scheme matures, and your money is paid back to you, a tax and financial planning firm. Most FMPs being launched these days have a maturity period or tenure ranging from a little over a month to a little over a year. There are FMPs for one month (up to 35 days), three months (up to 100 days), six months, one year (367-370 days), two years and three years — most common are one month, three months and one-year tenure.
And what are the returns these FMPs are likely to offer? The returns on a three-month FMP are at around 7.25-7.5% per year whereas the returns on a one-year FMP are around 8-8.5. This was confirmed by another head of fixed income of a mutual fund and a couple of financial advisors.
It was standard practice among mutual funds to give out indicative returns on FMPs before investors invested. They managed to do this because an FMP which matures in 370 days invests in financial securities maturing in the same time period. This gave mutual funds a fair idea about the returns on offer.
Depending on the return the securities maturing in one year were giving, the FMP gave an indicative yield to the mutual fund distributors. This practice was banned by the Securities and Exchange Board of India (Sebi) in early 2009. Mutual funds, of course have gotten around this by verbally communicating to their distributors on the likely return to be expected on an FMP.
FMPs vs FDs:
Most one-year FDs offer a return of around 6.5-7% to ordinary depositors and 7.5% to senior citizens (people over 60). Meanwhile, one-year FMPs offer a return of around 8-8.5%. So, at a very basic level, FMP returns are higher. Once we take into account the tax treatment for the gains made on both FDs and FMPs, the net return earned on an FMP is much better. What gives FMPs the edge is the greater tax efficiency they offer. In other words, on a tax-adjusted basis, the return on an FMP is higher than that of a bank FD. The entire interest earned on an FD is taxable, depending on the tax bracket you fall in. For those falling in the 30.9% highest tax bracket, the real return from a one-year fixed deposit paying an interest of 7% is around 4.84%
However, the return on an FMP is categorised as a capital gain. So, for a period of more than one year, an FMP is taxable at the rate of 10% without indexation or 20% with indexation, whichever is lower. For instance, an individual invests 50,000 in an FMP. The rate of inflation is 5% and the return on the FMP after 370 days is around 8%. This means that the investor gets 54,000 at maturity, which implies a gain of 4,000. This gain taxed at the rate of 10% would mean a tax payment of 400 and a net gain of 3,600 which would imply a return of 7.2% (see table). If we take indexation into account, the cost after inflation goes up to 52,500 (50,000 + 5% of 50,000). So, the capital gain in this case is 1,500 (54,000 – 52,500). And a 20% tax on this works out to 300, which is lower than the 400 tax that needs to be paid without indexation. So, the net gain is actually 3,700 (4,000 – 300), or 7.38% (3,700 expressed as a percentage of 50,000). Now compare this to 4.84% return you earn in case of a fixed deposit, it tells you very clearly where more money is to be made. The tax benefit due to indexation and the fact that interest on bank FDs is fully taxed makes FMPs a good bet.
How To Invest In An FMP?:
Mutual funds offer FMPs all the time. FMPs are more popular towards the end of a particular quarter. The month of September saw a launch of a lot of FMPs. Now, December will see a lot of schemes being launched
Should You Invest Now Or Wait?:
RBI has increased the repo rate (the rate at which it lends to the commercial banks) by 125 basis points in this financial year. If interest rates are poised to move further up, then it makes sense for investors to wait. If they are not, it makes sense for investors to lock in their money right now. We polled experts to get their view on this. And as is the case usually, they are divided on the issue.
The short-term interest rates are nearing their peak. This indicates an opportunity to lock in money with a one-to-three-year timeframe. Returns on short-term financial securities (which FMPs invest in) have already moved up and there is limited scope for returns to go up more.
But not all share the same opinion. Short-term interest rates are likely to go up further as the initial public offerings(IPOs) and follow-on public offerings (FPOs) by companies in the stock market will suck out money along with further issuances of certificate of deposits by banks. What this means in simple English is that the demand for money from corporates and banks is likely to go up in the days to come, thus pushing up interest rates further. Adds a head of fixed income of a mutual fund, I will not be surprised if the returns offered on FMPs with a greater than one year maturity touch even 9%.
So, given this disagreement among experts, it makes some sense to park your money in FMPs right now. You will be better off investing more than half of the money you allocated to FMP now. Why wait for a 20-25 basis point uptick in returns when you really cannot time it?" asks a strategist with a foreign wealth management services provider. The bigger issue is that there is no guarantee that retail investors get enough options in FMP space in the last quarter of the financial year. A bird in hand is better now than two in the bush later is the simple reasoning wealth advisors are offering as they advise investing now.
Risks of Investing In An FMP:
Generally, considered to be a safe instrument, nonetheless, retail investors should exercise care before committing their funds, given that returns on a bank fixed deposit are more or less guaranteed and returns on an FMP are not. Given this, it makes sense for investors to invest only in FMPs of mutual funds which
have a pedigree and reputation.
