Low Risk Appetite? Invest In FMPs

KEY POINTS:

An FMP is a fund that has a pre-determined closing date at which time all the units are compulsorily redeemed. The investor gets the market value of the units as on the closing date.

Simply having a pre-determined closing date does not make an FMP safer. Rather, it is the way the FMP is constructed that does so.

FMPs are suitable for investors who have no appetite for volatility, and would be willing to sacrifice the upside potential in open funds for the sake of predictability available in fixed plans.

Q) There are a number of Fixed Maturity Plans on offer that promise safe returns as compared to open-ended bond funds. Should I take my investments out of open-ended funds and put them in FMPs?

- Utkarsh Bhan

Before you make the decision, it is important to first understand the pros and cons of a Fixed Maturity Plan. An FMP is simply a fund that has a pre-determined closing date at which time all the units are compulsorily redeemed. The investor gets the market value of the units as on the closing date.

However, simply having a pre-determined closing date does not make it any safer! Rather, it is the way the FMP is constructed that makes it safer. For instance, a one-year FMP in debt would require the fund manager to invest the fund in bonds that mature on the same date as the FMP maturity date (which in this case would be 365 days). The issuer of the bond pays back the principal along with the coupon to the fund which, after deduction of fund management expenses, is paid back to the investor. It is expected that the fund manager does not trade on the portfolio in the interim.

The advantages of investing in FMPs are as follows:

1. The volatility of an open-ended fund which ‘marks-to-market’ the portfolio is absent in an FMP.
2. When you know the bonds in the portfolio, you can estimate the return that you would get fairly accurately, making it a predictable investment product. It is the predictability that many investors prefer FMPs.
3. For an investor in a high tax bracket, the post-tax returns compare favourably with those of fixed deposits.
4. The expense ratio in an FMP is generally very low, ensuring better transmission of returns to the investor.

The disadvantages of FMP investments are:

1. One cannot exit the FMP in between as it has a close-ended structure. One has to wait for the end date to get the investment back – so investors should be clear on their investment horizon. In case the units are in demat mode, they are tradable on the exchange but either liquidity is very low or discounts are very high.
2. As per the SEBI regulations, the AMC is not allowed to disclose its planned portfolio in advance nor is it allowed to tell the investors what return to expect.

Some misconceptions with respect to FMPs are:

1. The returns from an FMP are guaranteed: Well, no they are not. It is only more predictable than an open-ended fund.
2. It is 100 per cent safe: No, there is a risk attached. What is this risk? It is that of default by any of the bond issuers in the fund. This is sought to be mitigated by choosing ‘AAA’ or ‘AA’ rated bonds in the fund portfolio. Risky industries in the portfolio may be avoided by examining previous portfolios of the same AMC’s earlier FMPs.

To summarise, an FMP is suitable for an investor who has no appetite for volatility. Such an investor would be one who is willing to sacrifice the upside that could happen out of trading or mark-to-market gains in an open fund for the sake of predictability.