WHAT’S WRONG WITH FMPs?

Fixed Maturity Plans, with their higher indicative returns (than FDs) and tax advantages, have attracted huge amounts of investor money in recent months. But they are now embroiled in controversies. What are the problems? And how can you ensure that your investments in them remain safe?

Investors opt for equities for capital appreciation and prefer debt for safety of capital. With the equity markets declining steeply since the beginning of the year (the Sensex is currently down 48.1 per cent since January 1), debt has emerged as the preferred mode of investment.

Among debt instruments, fixed maturity plans (FMPs) offered by mutual funds have become quite popular with investors ? more than bank fixed deposits (FDs), especially among people in higher income tax brackets. While a 390-day FD today gives returns ranging from 9.5-10.75 per cent, FMPs offer an indicative yield as high as 12.5 per cent. With higher yield and tax advantage (FMPs of more than one year straddling two financial years offer double-indexation benefit), these products are mopping up large quantities of investors? short-term surpluses.

From Rs 69,256.10 crore on September 30, 2007, FMPs? assets under management (AUM) had nearly doubled to Rs 1,02,133.17 crore by September 30 this year (source: valueresearchonline). The fund count too has more than doubled from 477 last September to 975 this year. To boost sales, asset management companies (AMCs) have even started paying upfront commissions to distributors instead of trailing commissions. But last month, mounting redemption pressures put these plans in the spotlight for all the wrong reasons.

What are FMPs?
FMPs are close-ended funds that invest in debt paper and were first launched in India by Kotak Mutual Fund in 2001. These funds have a pre-defined maturity period that ranges from 15 days to three years. By definition, these funds invest in bonds whose maturity coincides with that of the FMP. For instance, a one-year FMP will invest in bonds that will mature in one year. A fund house collects moneys from investors and uses it to buy one-year bonds. At maturity, issuers of bonds repay the money with interest to the fund house, which in turn pays investors (minus its charges).

Besides promising indicative returns at the start of the tenure, FMPs also offer tax advantages. Under the growth option, when an FMP is held for over a year, the profit is liable to capital gains tax. This tax is payable at the rate of 10 per cent of capital gains, or by using indexation. In case of the dividend option, dividend distribution tax at the rate of 14.5 per cent is paid by the mutual fund before passing the dividend to the investor.

FMPs generally invest in company deposits, commercial papers and bonds issued by banks, real estate companies, and non-banking financial companies (NBFCs). In the current cash-starved environment, a lot of real estate companies and NBFCs sold their debt paper to mutual fund houses, promising higher returns.

Are FMPs safe?
As a product category, FMPs are very good instruments for parking your short-term surpluses, provided prudent investment choices are made by the fund managers. ?FMPs are good instruments for people who want to save tax and also get good returns,? says Veer Sardesai, a Pune-based financial planner.

What is the problem then?
Higher returns, better tax treatment: so where is the problem?

Well, the problem lies in disclosure norms. The market regulator, Securities and Exchange Board of India (Sebi), has not made it mandatory for AMCs to disclose the portfolio and details of underlying securities while selling an FMP. AMCs have taken advantage of this fact.

To lure more investors with higher indicative yields and to boast of higher AUMs, some AMCs have resorted to malpractices like allowing mismatches in maturity period (between FMPs and their underlying securities) and have also compromised on the credit quality of securities these FMPs invest in.

Maturity mismatch. With growing interest of retail and corporate investors in FMPs, and the avalanche of funds that followed, a few fund houses started investing in papers whose maturity period was different from that of the FMP. Say, for instance, a three-month FMP invested in one-year paper. (A one-year paper will give one percentage point higher yield than a three-month paper). This is known as maturity mismatch. By doing so, an AMC is taking a call on one, liquidity. At the time of redemption of the three-month FMP, the mutual fund house could be hard put to find the funds for paying off the investors because the fund has invested in higher-maturity securities.

And two, the AMC also courts interest-rate risk. If in the interim, interest rates rise, the value of the longer-duration bond would decline. If, under redemption pressures, the fund house is forced to sell off the bond before maturity, it will incur a loss.

Compromise on credit quality. To offer higher yields, AMCs also started compromising on the credit quality of the underlying debt paper they invested in. Real estate firms and NBFCs, which are starved for liquidity, offered to pay higher interest rates to AMCs. However, the inability of some of these borrowers to live up to their repayment commitments invited trouble for some AMCs. In fact, real estate companies have offered interest rates as high as 22-24 per cent on debt raised from mutual funds.

What should you watch out for?
First, be aware of the risks. The returns on FMPs are indicative, not assured, as is the case with fixed deposits.

Second, be prudent in your choice of investment. Resort to competent advice, say from a financial planner, while investing in an FMP. In the absence of such advice, check out the following while investing.

One, always buy such products from a reputed fund house.

Two, don?t get swayed by offers of higher returns. ?FMPs can give a higher yield mainly by dropping the credit quality of the paper they invest in. If one FMP is offering higher yield than the rest, then it is probably compromising on the credit quality of the paper. Investors should be wary if someone is offering a higher rate compared with peers,? says Sardesai.

Three, although it is not mandatory for an AMC to disclose the indicative portfolio, always ask for one before investing. Since the portfolio is merely an indicative list, ask the AMC if there will be any major change in the list.

Four, look at the credit ratings of the companies whose debt securities the FMP invests in. Make sure that the companies have been rated by an established credit rating agency and not by an unknown name, as is happening nowadays.

Strengthen regulation
FMPs are designed to provide steady returns in volatile markets by investing in rated debt instruments. However, laxity in regulation and malpractices by AMCs created panic last month. A few AMCs were unable to honour their commitments when cash-strapped corporates and high net worth investors sought redemption from FMPs before their maturity period.

With a few regulations in place, FMPs can work better. First and foremost, strict portfolio disclosure norms need to be put in place. Sebi should make it mandatory for a fund house to disclose its tentative portfolio to the investor. ?In the interest of investors, market regulator Sebi should ensure that the portfolio is well disclosed and written in a reader-friendly way,? says U.K. Sinha, chief executive officer, UTI Mutual Fund.

Mismatch in maturity between FMPs and their underlying securities should also be checked. There are some companies that publish their portfolios in the fact sheet. But experts feel that publishing the names of companies is not enough. AMCs should also mention the maturity period of the underlying asset, so that an investor is aware of maturity mismatches, if any.

Sebi should also ensure that AMCs invest only in high-quality debt paper that have good credit rating ? and that too from established rating agencies. Lastly, bifurcated data on investments made by corporates and retail investors should be available.