Sunday, July 27, 2008

FIXED MATURITY PLANS - BASICS

FMP's (Fixed Maturity Plans) are becoming increasingly popular among debt investors in recent times. Since conventional Income funds and Gilt funds are marked to market, in a scenario where interest rates are rising, these funds deliver low or even negative returns.

How does the mark to market concept work? If a mutual fund holds a debt security which gives 8 % per annum (coupon rate) payable yearly, it stands to receive Rs.8 by way of interest on Rs.100 invested. Now if the market rate of interest on bonds of similar tenure increases to 9 % an investor in these bonds would get Rs.9 for Rs.100 invested. The older bond gets less attractive and its price would have to be readjusted to reflect the new market reality. Since the coupon rate (8 %) is fixed, the price of the bond is adjusted to Rs.99 (approximately), so that an investor gets the same return whether he invests in the new bond or old. This is a simple example of a 1 year bond. In case of longer duration bonds the price of the bond is adjusted to reflect the notional loss in interest over the duration of the bond.

If interest rates fall in the market, then conversely, the older bonds would be more valuable and their prices would increase to more than their face value. This concept of adjusting the price of the bond to reflect the changing interest rate dynamics in the market is called marking to market. This is the reason why, presently income funds are suffering from poor returns in the current period of rising interest rates.

An investor holding the bonds to maturity would still receive his principle back along with the coupon rate. This is the concept on which FMP's work. Investors are locked into the scheme until its maturity and intermediate withdrawals are permitted with very high exit loads. So whether interest rates rise or fall in the markets, investors get more or less the indicated yield at the beginning of the scheme. This is a useful instrument for investors who need the security of returns above all else and are not willing to leave it to the vagaries of the market.

FMP's act like Fixed deposit schemes of banks but are more tax efficient due to their structure of not promising any returns. Because of this, the returns from long term FMP's (more than 1 year duration) are subject to capital gains tax, the rate of which is less than the income tax rate for individuals in the higher tax brackets. Again in case of shorter duration FMP' s the interest generated is paid out in form of dividends which are tax free in nature and a percentage is deducted towards dividend distribution tax. Dividend distribution tax rates also being lower than the income tax rates, investors in the higher tax bracket stand to benefit from short term plans.

FMP's have the disadvantage of being illiquid and any withdrawals before the completion of the scheme are permitted only with high exit loads. Therefore investors should only invest in FMP's if they are absolutely sure that they would not require the funds over the duration of the scheme.

5 comments:

Uma said...

wow! great article, I didn't know any of this. what a lot I missed out on!

Mahendra Naik said...

Thanks, Uma.

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VALUE STOCKS UNDER TWO DOLLARS said...

I am not sure about Fixed muturity plans.

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