FMP - Fixed Maturity Plans

Fixed maturity plans (FMPs) seem to have a lot going for them. Indicative yields have risen to as high as 11.5% of late, giving them a clear edge over fixed deposits (FDs) and drawing in ever more investors. By some estimates, almost Rs 1,00,000 crore has been invested in these schemes since the beginning of this year.

Let's try to understand what makes these instruments so popular.

What is an FMP?

An FMP is a closed-ended mutual fund, which invests in debt securities. Thus, unlike open-ended mutual funds where an investor can enter and exit at will, one can invest in an FMP only during the new fund offer period. Every FMP has a certain maturity period, varying from a month to 3 years. Investors who want to exit before maturity typically need to pay an exit load of 2%.

What kind of returns do FMPs give?

FMP returns vary depending on the state of the debt market. If interest rates are on the higher side, then the returns offered by FMPs are also high. This is because FMPs invest in debt securities issued by corporates and if the interest rates offered on these securities are high, the FMP returns also go up.

Currently, returns offered on FMPs of one-year maturity are between 10.5% and 11.5%. FMPs typically give out indicative yields to their distributors at the time of launch - this is the annualised return they hope to earn.

How do FMPs indicate yields in advance?

Mutual funds have a fair idea of the debt securities on offer and the interest rates going on them. They try and match the tenure of the debt securities chosen for investment by them with the period of maturity of the FMP. This way, they are able to lock in the return at the very beginning and thus calculate the indicative yield.

Is higher indicative yield the only criterion for selecting an FMP?

There is no simple answer to that as the yield has been projected on the assumption that every debt security the FMP invests in will pay up at the end of the tenure. In a bid to offer a higher indicative yield, some mutual funds end up investing in highly risky debt securities. Since the risk involved is higher, the interest offered on these FMPs is also higher, and so is the indicative yield.

Investors should check up on the portfolio of investments planned by the FMP before taking the plunge. If it lists a lot of debt securities with ratings of less than AA, it is best to avoid investing. Remember, AAA is the highest rating.

How is the tax calculated?

Like other mutual funds, returns on FMPs are categorised as capital gains.

If you invest in an FMP with a maturity of less than one year, the entire capital gain is lumped on to your income for the year and taxed according to the tax bracket you fall into. So, if you are in the top tax bracket of 33.99%, the short-term capital gain on an FMP will be taxed at that rate.

For FMPs with maturity of one year or more, one needs to pay long-term capital gain tax, which is charged at 10% without indexation or 20% with indexation, whichever is lower. Say you invest Rs 50,000 in an FMP of one-year maturity at Rs 10 per unit and hence get 5,000 units. The indicative yield on the FMP is 11%.

At the time of maturity, the FMP meets that yield and so at maturity, the net asset value of one unit stands at Rs 11.10 (Rs 10 + 11% of Rs 10), which takes the total value of 5,000 units to Rs 55,500 (5,000 x Rs 11.10). This means a long-term capital gain of Rs 5,500 (Rs 55,500 - Rs 50,000), on which tax at the rate of 10% works out to Rs 550. So, the net gain would be Rs 4,950 (Rs 5,500 - Rs 550).

The indexation method takes into account inflation while calculating the purchasing price. For this, the government issues index numbers every year. These numbers are available in the instructions accompanying Indian Income Tax Return forms.

Say the index number for the year in which the investment is made is 600 and the index number in which the investment matures is 650. One can divide 650 by 600 and multiply the resultant multiple (1.083) with the cost of purchasing the units (Rs 50,000) to arrive at the indexed cost (Rs 54,167). So the capital gain is Rs 833 (Rs 55,000 - Rs 54,167).

Tax on Rs 833 at the rate of 20% works out to Rs 167, which is lower than Rs 550 arrived at by taking the 10% rate without indexation, and is the tax to be paid. The post-tax capital gain thus works out to Rs 5333 (Rs 5,500 - Rs 167), giving a post-tax yield of 10.67%.

Are returns on FMPs higher than on FDs?

The interest earned on a fixed deposit (FD) is lumped with the remaining income for the year and taxed according to the highest tax bracket the individual is in, irrespective of whether the FD has a maturity of less than one year or equal to or more than one year. Given this, FDs of one year or more give a much lower rate of return than FMPs.

Take an FD, which matures in one year and gives an interest of 11% (similar to the indicative yield of the FMP). If the individual is in the top tax bracket, the post-tax return works out to 7.26% (11% - 33.99% of 11%). This is much lower than the indicative yield on the FMP. Even in the lowest tax bracket of 10.3%, the post-tax return of an FD stands at 9.86% (11% - 10.3% of 11%).

Most one-year FDs offer much lower interest rates than the indicative yields on FMPs. But then, the returns on FMPs are at best indicative andnot guaranteed, which makes FDs a safer bet.

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