Fixed Term Plans & Debt Funds
Introduction
While equity funds are for wealth creation, debt funds focus on stability and income. Among debt funds, a unique category called Fixed Maturity Plans (FMPs) is popular among High Net Worth Individuals (HNIs) and corporates. FMPs are essentially the mutual fund equivalent of a Bank Fixed Deposit (FD), but with potentially better tax efficiency.
What is a Fixed Maturity Plan (FMP)?
Definition: An FMP is a close-ended debt mutual fund with a pre-defined maturity period (e.g., 1100 days, 3 years, 5 years). It is open for subscription only during the NFO period.
Investment Strategy:
- The fund manager buys debt instruments (bonds, CDs, commercial papers) that mature on or before the maturity date of the scheme.
- Hold to Maturity: The manager holds these bonds until they mature, eliminating interest rate risk (market fluctuation).
- Locked-in Yield: Investors get an "indicative yield" (approximate return) based on the current rates of the bonds purchased.
Why Invest in FMPs? (The Double Indexation Benefit)
Historically, the biggest selling point of FMPs (especially 3-year+ FMPs) was the tax advantage over Bank FDs.
Bank FD vs FMP Taxation
- Bank FD Interest: Added to income and taxed at your slab rate (up to 30%).
- FMP (Debt Mutual Fund): If held for > 3 years, gains are taxed at 20% with Indexation.
- Update: Note that for FMPs launched after April 1, 2023, the indexation benefit was removed for debt funds investing < 35% in equity. They are now taxed at slab rates, similar to FDs.
- Legacy Concept: However, for academic purposes, understanding the "Indexation Benefit" is crucial as it defined this product category for decades.
Types of Debt Funds (Based on Tenure)
Apart from FMPs (which are close-ended), open-ended debt funds are classified by SEBI based on the duration of their portfolio:
- Overnight Fund: Matures in 1 day. Safest.
- Liquid Fund: Maturity up to 91 days. Used for emergency funds.
- Ultra Short Duration: 3 to 6 months.
- Short Duration: 1 to 3 years.
- Medium Duration: 3 to 4 years.
- Long Duration: > 7 years. (High interest rate risk).
- Gilt Fund: 100% in Govt Securities (No credit risk).
Comparison: FMP vs Bank Fixed Deposit
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Risks in Debt Funds
Investors often mistake "Debt Fund" for "Risk-Free". This is incorrect.
- Credit Risk: The company issuing the bond might default on payment (e.g., IL&FS crisis).
- Interest Rate Risk: When market interest rates rise, bond prices fall. Long-duration funds suffer the most. FMPs mitigate this by holding to maturity.
- Liquidity Risk: Inability to sell the bond in the market when needed.
Exam Notes: Writing the Answer
Question: "What are Fixed Maturity Plans (FMPs)? How do they differ from Bank FDs?" (10 Marks)
Model Answer:
Fixed Maturity Plan (FMP) is a close-ended debt mutual fund scheme with a fixed tenure (maturity).
Features:
- Close-Ended: Subscription only during NFO.
- Strategy: Invests in bonds matching the scheme's tenure and holds them till maturity to lock in yields.
- Risk: Low interest rate risk (due to hold-to-maturity) but subject to credit risk.
Difference from Bank FD:
- Returns: FD returns are fixed/guaranteed. FMP returns are indicative (market-linked).
- Liquidity: FDs allow premature breakdown. FMPs can only be sold on stock exchange (often illiquid).
- Safety: FDs have DICGC insurance. FMPs carry market risk.
Conclusion: FMPs are suitable for investors who can lock in money for a specific period and want returns slightly higher than FDs with tax efficiency (subject to current laws).
Summary
- FMP: Close-ended debt fund, fixed tenure, matches bond maturity profile.
- Hold-to-Maturity: Strategy to eliminate interest rate volatility.
- Debt Categories: Liquid, Short Duration, Gilt (Govt Bonds), Corporate Bond.
- Risks: Credit Risk (Default) and Interest Rate Risk are key in debt funds.
Quiz Time! 🎯
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