Investing In FMPs & Open-Ended Funds

I invested in SBI DFS-367D-10 last year, which matured on November 22, 2012. Should I invest the money I earned in another one-year FMP or in an open-ended debt fund?

- Nishith Panemanglor

Your return from your investment in the fixed maturity plan (FMP) is about 9.2 per cent (NAV as on November 22, 2012). While this looks attractive, you would probably be better off investing in short-term open-ended debt funds over the next one year.

Over the last one year, short-term funds have generated higher returns than the FMP you invested in. This can be attributed to the fact that the one-year rates have fallen by approximately 80 basis points.

A quick glance through the portfolios of one-year FMPs that have been closed recently will show that these funds have predominantly invested in certificates of deposits (CDs). As FMPs effectively try to align the maturity of their portfolios to the maturity of the scheme, your returns from a one-year FMP will be slightly less than the one-year CD rate (currently 8.75 per cent).

Over the next year, short-term funds may generate higher returns if the interest rates decline. This is quite probable because the interest rate cycle appears to have peaked. Inflation, which averaged about 9.5 per cent during 2011, has now fallen to 7.24 per cent. India’s GDP growth has also dropped significantly over the last few quarters. Economic growth in the first six months of the current fiscal year is 5.4 per cent – a significant decline from the growth of 7.3 per cent recorded in the same period last fiscal (Source for inflation and GDP data: MOSPI). The RBI has adopted a slightly more dovish stance towards inflation, and may lower interest rates to spur growth and investment. In its second-quarter monetary policy review announced on 30th October, 2012, the RBI governor, Dr Subbarao said that there may be “a reasonable likelihood of further policy easing in the fourth quarter of this fiscal year”.(RBI: Second Quarter Review of Monetary Policy 2012-13)

As the interest rate trajectory is downwards, you would benefit from capital appreciation by investing in an open-ended debt fund. While FMPs do limit downside risks in times of rising interest rates, they offer no upside potential when the rates are falling. This is because the fund manager simply holds the securities till maturity.

Also, you may suffer from reinvestment risks if you invest in an FMP. In a year’s time, if the interest rates are lower, you would have to reinvest your securities at a lower rate. In contrast, the fund manager of an open-ended debt fund generally holds a mix of securities with different maturities in the portfolio. This will effectively mitigate reinvestment risk, as the bonds in the portfolio will mature at different times.

Transparency is another benefit that open-ended funds offer. As per SEBI regulations, FMPs are not allowed to disclose indicative yields or portfolios while they are open for investment. The Scheme Information Documents (SIDs) and Key Information Memorandums (KIMs) etc. show only the intended asset allocation (within five per cent). This will indicate how much the fund intends to invest in CDs, CPs, NCDs, etc. However, you will not be able to find out what companies the fund manager plans to invest in. In contrast, if you want to invest in an open-ended fund, you can look at the fund’s monthly factsheet for its portfolio, which will contain details of the type of securities and companies the fund has invested in.

You could invest in short-term funds like Birla Sun Life Dynamic Bond Fund, IDFC Super Saver Income Fund (SSIF)-Medium Term Plan or Templeton India Short-Term Income Plan (TISTIP). These funds are the best performers in their category. The following tables highlight the performance and features of these funds.

TISTIP focusses on generating returns through accrual income. The fund predominantly invests in corporate bonds at the shorter end of the yield curve and tries to minimise interest rate volatility. It generally has a higher YTM relative to its category, as it is overweight on ‘AA’ instruments.

Birla Sun Life Dynamic Bond Fund is an actively managed fund that aims to generate returns through a portfolio of bonds and upto 25 per cent in government securities. The fund may also invest in structured credit. IDFC SSIF-MT generally invests in a mix of accrual income and capital appreciation. The fund predominantly invests in a mix of corporate bonds and certificate of deposits and upto 25 per cent in government bonds. Relative to TISTIP, BSL Dynamic Bond and IDFC SSIF-MT are slightly more aggressive funds with higher volatility.

Note that short-term funds are only suitable if you have an investment horizon of at least 12-18 months.

In conclusion, by investing in an open-ended debt fund, you can benefit from higher yields and capital appreciation (if interest rates fall). For additional returns, you may wish to consider investing in medium to long-term debt funds such as Templeton India Corporate Bond Opportunities Fund, ICICI Prudential Corporate Bond Fund or Templeton India Income Opportunities Fund. However, be aware that open-ended funds may have exit loads.