There are two broad categories of mutual funds viz. Open ended mutual funds and Closed Ended Mutual Funds.
What are Open-ended and Closed Ended Mutual Funds?
In case of an open-ended mutual fund, you can enter and exit fund scheme whenever you want i.e. you can buy units from the fund house and sell the units back to the fund house whenever you want. All the popular mutual fund schemes are open-ended mutual funds.
Closed-ended funds are open for subscription only during the New Fund Offer (NFO) period.
Once the NFO period is over, you cannot buy new units from the fund house. You can’t even sell these units back to fund house before the closed-ended mutual fund matures (tenure ends). The units are listed on stock exchanges. If you want, you can sell the units on stock exchanges. However, there is little liquidity in these schemes and you are virtually locked in until the fund tenure is over.
When the tenure ends, you can either take back your money or the fund house may give you an option to roll over your investment. Closed-ended mutual funds come in both equity and debt variants.
In this post, I will talk about Fixed Maturity plans, which are closed ended debt mutual funds.
What are Fixed Maturity Plans (FMP)?
A FMP is a debt mutual fund that invests in fixed income securities (just like any debt mutual fund). However, since it is a closed ended debt mutual, there are restrictions on when you can enter and exit the scheme. Well, I assume exit in the secondary market is not possible.
With FMPs, the fund manager typically matches the maturity of underlying securities with that of FMP maturity. For instance, if the FMP matures in 4 years, the fund manager will select bonds/ securities that mature on or before the maturity date of the plan. This approach effectively takes away the interest rate risk from the investment. More on this later.
Should you invest in Fixed Maturity Plans (FMPs)?
Let’s consider these aspects.
#1 FMPs have little liquidity
As mentioned earlier, Fixed Maturity Plans are closed ended debt mutual funds. Therefore, you cannot exit easily.
Technically, you can exit in the secondary market (exchanges). However, you need to own such units in demat format (in your demat account) and need a buyer to purchase units from you.
The liquidity in FMPs is virtually zero. Hence, it is quite unlikely you will be able to exit your FMP investment before FMP maturity.
In a way, you are sacrificing liquidity by investing in FMP.
I don’t think it is worth it.
#2 Fixed Maturity Plans (FMPs) are not Fixed Deposits
If the fund manager purchases debt securities (or make debt investments) whose maturity coincides with the maturity of the FMP (which is typically the case), the interest rate risk and the market risk is effectively taken care off.
This is under the assumption that you won’t seek an exit in the secondary market.
For instance, if your FMP matures in 4 years and the fund manager invests in only those securities that mature in about 4 years, the underlying securities will mature just before the FMP maturity. The fund manager will simply pass on the cash flow from the securities to you. Therefore, you don’t need to be worried about interest rates falling or rising in the interim.
By the way, it may not be compulsory for the fund manager to match the maturity of debt securities with the maturity of the FMP. If the maturities are widely different, then you are exposed to reinvestment risk when the securities are rolled over in FMP portfolio.
However, FMP does not take care of the credit risk. Therefore, if there is a default on any underlying security, you can suffer capital loss (just as in an open-ended fund).
#3 Extra indexation with FMPs?
For debt mutual funds, if you hold units for over 3 years, the resulting capital gains qualify as long term capital gains. Long term capital gains get favorable tax treatment and are taxed at 20% after indexation.
If you purchase on March 28, 2017 and redeem on March 31, 2020, the resulting gains will qualify as long term capital gains (since the holding period is greater than 3 years).
Cost inflation index for 2017 and 2020 will be used to index cost of purchase.
An interesting part is that if you hold on to the investment for a 1 more day, you will get even greater indexation benefit. For instance, if you sell on April 1, 2020, you are selling in FY2021.
Therefore, you will get indexation benefit for 4 years i.e. Cost inflation index for 2017 and 2021 will be used to index cost of purchase.
This will effectively increase the indexed cost of purchase and reduce your tax liability.
Let’s consider an example.
It is for this reason that many FMPs are launched at the end of the year to take advantage of this extra indexation benefit.
Earlier, when holding period in debt funds to qualify as long term capital gain was just 1 year (was increased to 3 years in 2014), many FMPs used to be launched in March and used to mature in April next calendar year. The duration of those FMPs used to be about 370-380 days.
Now, the duration of FMPs has increased to over 1,100 days i.e. a little over 3 years so that you get the extra indexation benefit).
So, this feature is not exclusive to FMPs. Any debt mutual fund, if purchased smartly for the right period, will qualify for such benefit.
Therefore, no special tax benefit for FMPs.
Point to Note (difference between FMP and open-ended debt fund schemes)
Duration of FMP portfolio (if the maturity of FMP and underlying securities is matched) reduces with time. Here I am talking about duration as a measure of interest rate sensitivity.
In case of an open-ended debt mutual fund, this is not the case. For instance, a short term debt mutual fund may have a duration of 2-5 years today. Even after 5 years, the duration may stay the same. Why? Because that is the mandate of the fund. This is also why it is a mistake to pick up an open ended debt fund where the current duration matches with your investment horizon.
Your investment horizon will reduce as the time goes by but the duration of the fund will stay the same exposing you to interest rate risk.
Stick to open-ended debt mutual funds. I prefer debt mutual funds with shorter duration and that invest in high credit quality securities (mostly ultra-short term debt mutual funds).
I do not see any need for FMPs in your mutual fund portfolio. However, if you want to take exposure, do go through the Scheme Information document to understand the kind of securities the scheme will invest in.
Always remember FMPs are not without risk. By matching maturity, interest rate and market risk can be taken care off but not credit risk. You will also be sacrificing liquidity by investing in FMPs.
Do note shorter the duration ( a measure of interest rate sensitivity of bond portfolio), lower is the interest rate risk. If you (like I do) prefer to invest in shorter duration funds (Ultra short term or liquid funds), interest rate risk is anyways quite low. What value will a Fixed Maturity Plan (FMP) add in that case?
Latest posts by Deepesh Raghaw (see all)
- How to Update Information in your Aadhaar Card? - October 18, 2017
- Categorization of Mutual Fund Schemes by SEBI - October 17, 2017
- What to do if you have two NPS accounts? How to close the second NPS account? - October 6, 2017
- Primer: Income Tax Calculations for Beginners - October 6, 2017