At a time when the equity markets are in choppy and interest rates are stabilizing, it is natural for investors to gravitate towards debt instruments. At the same time, there are a few who believe that the market has bottomed out. So neither do they want to miss on the upside, should the market take a U-turn. The AMCs have found a way out by introducing equity-linked fixed maturity plans (FMPs), which will invest in equity-linked debentures. Unlike a normal debenture, where the interest rate (coupon rate) is fixed, in these debentures, the interest rate depends on an underlying basket of stocks. These stocks could be a select few chosen by the fund manager or it could be an index. Depending on the performance of the stocks, the return on the debenture is fixed. So how is this figure arrived at? Simply by looking at the Participation Ratio.
Let's say that the debenture is linked to the Sensex at a 100 per cent Participation Ratio. Should the Sensex rise by 10 per cent, then the debenture issuer will pay the debenture holder 100 per cent increase of the underlying asset, which is 10 per cent in this case. But this rise is paid on a proportionate basis. For instance, if the Sensex rises by 10 per cent only in six months, then the interest will be paid solely for such a period. But there is also a limit to the potential upside. This is known as the knock-out level and the rate of interest paid at this level is known as the knock-out coupon rate.
For example, let's say the knock-out level for the Sensex, which is at 13,000, is fixed at 18,000 and the knock-out coupon rate is fixed at 30 per cent. During the tenure of the scheme, if the Sensex hits the knock-out level or even goes higher, the investor will only get 30 per cent during that period. But what if the Sensex falls below its initial level? The investors will get the principal amount back with no extra return.
So how does it work in an FMP? When an investor invests Rs 100 in an equity-linked FMP, Rs 78 is invested in an equity-linked debenture. If there is an upside in the market or underlying stocks, the investor will benefit. If not, he will at least get his principal amount back on maturity (Rs 100). Hence, the capital is protected. The balance Rs 22 (Rs 100- Rs 78) is invested in Options to generate the extra return.
An equity-linked FMP is neither a pure debt investment, nor a pure equity one. Theoretically, it sounds great for investors who are not clear about the stock market direction over the next few years but would like to participate in its upside potential, if any. But should the market stay flat or dip, the investor will suffer. And in such a scenario, a regular FMP or debt fund could well deliver superior returns.
Let's say that the debenture is linked to the Sensex at a 100 per cent Participation Ratio. Should the Sensex rise by 10 per cent, then the debenture issuer will pay the debenture holder 100 per cent increase of the underlying asset, which is 10 per cent in this case. But this rise is paid on a proportionate basis. For instance, if the Sensex rises by 10 per cent only in six months, then the interest will be paid solely for such a period. But there is also a limit to the potential upside. This is known as the knock-out level and the rate of interest paid at this level is known as the knock-out coupon rate.
For example, let's say the knock-out level for the Sensex, which is at 13,000, is fixed at 18,000 and the knock-out coupon rate is fixed at 30 per cent. During the tenure of the scheme, if the Sensex hits the knock-out level or even goes higher, the investor will only get 30 per cent during that period. But what if the Sensex falls below its initial level? The investors will get the principal amount back with no extra return.
So how does it work in an FMP? When an investor invests Rs 100 in an equity-linked FMP, Rs 78 is invested in an equity-linked debenture. If there is an upside in the market or underlying stocks, the investor will benefit. If not, he will at least get his principal amount back on maturity (Rs 100). Hence, the capital is protected. The balance Rs 22 (Rs 100- Rs 78) is invested in Options to generate the extra return.
An equity-linked FMP is neither a pure debt investment, nor a pure equity one. Theoretically, it sounds great for investors who are not clear about the stock market direction over the next few years but would like to participate in its upside potential, if any. But should the market stay flat or dip, the investor will suffer. And in such a scenario, a regular FMP or debt fund could well deliver superior returns.
