Should you invest in Fixed Maturity Plans (FMP)?

Open any mutual fund website or the MF NAV page of the newspaper and you are likely to be grabbing attention towards a product called fixed maturity plans (FMPs). What exactly are these plans and how do they fit into your investment scheme of things. A Fixed Maturity Plan (FMP) is a closed-ended fund that invests mostly in debt instruments (government bonds, institutional debt etc). That is the where the key advantage of an FMP comes in. Since it is a closed-ended fund, it can invest in instruments whose unexpired maturity precisely matches with the tenure of the FMP. For example, a 3-year FMP will invest in debt with an outstanding term to maturity of 3 years. So the yield is not only indicative but to an extent, it becomes like an assured return product. It is also free of any interest rate risk since it is locked in till the date of maturity. This helps eliminate the interest rate risk or the risk of price depreciation almost entirely. Such products can have a lot of value in the current scenario when the RBI has already hiked rates by 50 basis points and looks all set to go for a few more rate hikes.

Should you invest in Fixed Maturity Plans FMP 1 Should you invest in Fixed Maturity Plans (FMP)?

How do FMPs score as an investment and financial planning product?

  • FMPs offer the safety and security of debt instruments. Debt securities are, anyways, much safer and more stable compared to equities. Most FMPs invest in highly rated instruments like government bonds, institutional debt; “AAA” rated debt etc so that the default risk aspect is almost eliminated. With low default risk and limited price risk, the FMPs almost work like an assured return product for investors.
  • Since FMPs are closed ended funds, there is no scope for any price risk as funds are locked in. Hence any rise in interest rates does not have any negative impact on the NAV of the fund. This is specifically useful for institutional investors who need to provide MTM losses ( Mark-to-market losses ) in their books. Since FMPs are closed ended they are locked into fixed returns and hence there is no interest rate risk in FMPs. As a result, they are the ideal product in a rising interest rate scenario.
  • Compared to the traditional bank FD, FMPs are more tax efficient. When you invest in bank FDs, the interest earned is taxed at your peak rate of tax. So if your tax rate applicable is 30% then the tax on your FD interest is 31.2% (including cess). In case of FMPs always opt for the growth plan. The dividend plan may not be too efficient as the dividend distribution tax (DDT) is around 29.12% including the surcharge and cess and is almost as high as the bank FDs. Hence you should ideally prefer a growth plan.
  • When it comes to FMPs, the tenure matters a lot. If the tenure of the FMP is up to 3 years, it is treated as STCG (short-term capital gains ). That means the capital gains will be taxed at your peak rate of 31.2% and hence there is no special advantage in the FMP, except that returns are higher than in the case of bank FDs. However, if the FM is held for more than 3 years, then it becomes LTCG and will be taxed at a concessional tax rate of 20% along with the benefit of indexation. Indexation is the benefit that the tax department gives you to compensate for asset inflation over the years. If you bought an asset at half the price 10 years back then it is unfair to charge you the full capital gain. Let us look at indexation and the dual indexation benefit of FMPs in greater detail.

OPEN ACCOUNT BUTTON 2 Should you invest in Fixed Maturity Plans (FMP)?

The benefit of double indexation in FMPs

What is this double indexation benefit on FMPs? Assume that you purchase an FMP at the end of the financial year and then sell it after holding it for a little over 3 years at the beginning of the fourth fiscal. Your holding period is just a little over 3 years but the benefit of indexation you get is increased by 1 year. How is that?

Let us see how the benefit of double indexation works in practice. Many fund houses issue their FMPs around the end of a financial year for a period of 1100 days and redeem their FMPs at the beginning of the fourth fiscal year to maximize the double indexation benefits. Here is how it works in practice and here is how the tax incidence comes down drastically.

Particulars

370 Day FMP

Double Indexation

Tax Benefits accrued

Date of FMP issue

March 29th 2014

Index Value on 29-3-2014

220

Date of Redemption

April 03rd 2017

Index Value on 03-4-2017

272

Tenure of the FMP

1100 days

Index Factor (272/220)

1.236

FMP purchase NAV

Rs.100.00

Indexed cost of Purchase

Rs.123.60

Annual Return

9.5%

Redemption Value

Rs.131.46

FMP Redemption NAV

Rs.131.46

Indexed Capital Gain

Rs.7.86

LTCG

Rs.31.46

LTCG at 20%

Rs.1.57

Effective Tax Rate

4.99%

Gains post LTCG tax

Rs.29.89

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

By holding for just 5 days more than 3 years, you have got additional tax benefits. The big advantage that FMPs offer is that they can be double indexed by timing the issue and redemption. In this case, the investor gets the benefit of 4 years of indexation. Effectively, the tax rate for the investor is just 4.99%. For FMPs to really tax efficient, you need to go for an FMP of 3 years so that it is classified as LTCG. Of course, double indexation is the icing on the cake.

To invest in Mutual Funds in direct mode?  Visit us at https://mf.tradeplusonline.com/

banner Should you invest in Fixed Maturity Plans (FMP)?

Related Post

Add a Comment

Your email address will not be published.