Switch To FMPs For Stable Returns

Two years ago, I invested in LIC Nomura Bond Fund and Principal Government Securities Fund. To save tax should I hold these funds or switch to fixed deposits? My tax slab is 30 per cent. I am using these funds to add to my savings as I plan to buy a house next year.

- Soumillya Biswas

You should redeem your investments in these funds as they are long-duration income funds. These funds are not suitable for your portfolio as your time horizon is relatively short. The NAVs of these funds may fluctuate more in response to changes in interest rates. This is especially true of Principal Government Securities Fund as the fund invests the majority of its corpus in government bonds (the prices of these bonds usually fall more than the prices of comparative corporate bonds when yields rise). Furthermore, these funds have underperformed their respective benchmarks as shown in the table below:

In the current scenario, you would probably be better off investing in fixed maturity plans (FMPs) rather than in open-ended debt funds. This is because fixed income markets may be unpredictable in the short run if the rupee continues to depreciate. In July, the RBI imposed emergency liquidity tightening measures to stabilize the currency and discourage speculation in the rupee. The central bank’s shock tactics led to volatility in the fixed income markets. The returns of debt funds of various maturities (including short-term funds) fell after the central bank’s announcement as yields of various debt instruments rose.

Hence, FMPs are a safer bet as these funds have a hold-to-maturity approach and have virtually no interest rate risk. FMPs are more tax-efficient than fixed deposits as you can save tax by investing in growth options since your investment horizon is one year. You will incur long-term capital gains tax and you can choose to pay either 10.3 per cent without indexation or 20.6 per cent with indexation. Your accountant or financial advisor can help you decide whether you will be better off with or without indexation.

A quick glance through the key information memorandums (KIMs) of some FMPs will show you that FMPs with one-year maturities generally invest almost their entire corpus in certificates of deposits (CDs). Since FMPs effectively try to align the maturity of their portfolios to the maturity of the scheme, your return from a FMP over the next year will be approximately equal to the one-year CD rate. On August 27, the interest rate on one-year certificates of deposits was about 10.60 per cent (Source: Deutsche Mutual Fund). After tax and expenses, your return should be around 9 per cent, assuming you pay tax at 10.3 per cent without indexation.

In conclusion, you should exit LIC Nomura Bond Fund and Principal Government Securities Fund and switch to one-year FMPs for stable returns over the next year. These close-ended funds should limit downside risk and will generate higher post-tax returns than comparable investments in fixed deposits. However, remember to check the KIM of the FMP you invest in as some FMPs may also invest a small portion of their portfolios in commercial papers or bonds. These instruments are relatively more risky than CDs of comparable maturities.