Why Fixed Maturity Plans are better than FDs

Simran Sharma, 36, sat in her rocking chair brooding over her troubles. Last year, she had got divorced and had the custody of her five-year-old, school-going daughter, Aarohi.

Although the separation was painful, the financial settlement between Simran and her husband was arrived at amicably. She had managed to keep the house and also got a tidy lump sum of Rs 25 lakh from her ex-husband. She had invested most of the money in a bank fixed deposit.

Simran had no experience of the actual nitty-gritty of running a household and was in a dilemma on how to maintain her standard of living. A huge chunk of her income was used for maintenance charges of her flat, utilities, school fees, car expenses, hobby classes for her daughter, etc.

A visit to her chartered accountant had made her head spin. She had not realised that income tax would eat up such a large chunk of her interest income.

She knew her ex-husband had been generous and could not afford to shell out any more money.

She was not interested to dabble in the stock market as she could not afford to lose a precious rupee of her kitty. She was at her wits' end trying to find ways to augment her income without eating into her principal. 

She sought the advice of her friend, Avinash, who was an investment adviser. He recommended investing in fixed maturity plans of mutual funds and explained to her how they function.

What are fixed maturity plans?

FMPs, as they are popularly known, are the equivalent of a fixed deposit in a bank, with a caveat. The maturity amount of a fixed deposit in a bank is 'guaranteed', but only 'indicated' in the FMP of a mutual fund. The regulator does not allow fund companies to guarantee returns, and hence the 'indicated returns' in FMPs.

Typically, the fund house fixes a 'target amount' for a scheme, which it ties up informally with borrowers before the scheme opens. Since the fund house knows the interest rate that it will earn on its investments, it can provide 'indicative returns' to investors.

FMPs are debt schemes, where the corpus is invested in fixed-income securities. The tenure can be of different maturities, from one month to three years. They are closed-ended in nature, which means that once the NFO (new fund offer) closes, the scheme cannot accept any further investment.

These FMP NFOs are generally open for 2 to 3 days and are marketed to corporates and well-heeled, high net-worth individuals. Nevertheless, the minimum investment is usually Rs 5,000 and so a retail investor can comfortably invest too.

FMPs usually invest in certificate of deposits (CDs), commercial papers (CPs), money market instruments, corporate bonds and sometimes even in bank fixed deposits.

Depending on the tenure of the FMP, the fund manager invests in a combination of the above-mentioned instruments of similar maturity. Say if the FMP is for a year, then the fund manager invests in paper maturing in one year.

The prevalent yield minus the expense ratio, which varies from 0.25 to 1 per cent, will be the indicative return which can be expected from the FMP.

The expense ratio is mentioned in the offer document. The yield can be indicated fairly accurately because these schemes are open only for a short while.

The fund received is for a pre-specified tenure and the exit load from this plan is high (usually 1 per cent to 3 per cent, depending on the time of redemption). So, the fund manager has the liberty to deploy most of the funds mobilised under the scheme.

The actual return can vary slightly, if at all, from the indicated return. Against that, a bank fixed deposit exactly prints the amount which is due to you on maturity on the FD receipt. However, FMPs do earn better returns than fixed deposits of similar tenure.

As Avinash explained to Simran, the magic is in the tax treatment of a mutual fund FMP. FMPs are classified under the debt scheme category and enjoy certain tax benefits, such as:

• Dividend in the hands of the investor is tax-free. But the mutual fund has to deduct a dividend distribution tax of 14.025 per cent in the case of individuals and Hindu Undivided Families (HUFs), and 22.44 per cent in the case of corporates.
• Long-term capital gains (investment of more than a year) enjoy indexation benefit.
• Short-term capital gains are added to the income of the investor and taxed as per his/her slab, whereas the interest on a bank deposit (except where special 80C approved) is added to the income of the investor and taxed as per his/her slab.

The results of all these are quite dramatic.

Avinash took the example of a 90-day FD yielding 8 per cent, compared with an FMP yielding 8 per cent for an individual investor in the highest tax bracket.

Actually, the dividend distribution tax is deducted on the gross yield. So the return from the dividend option can be 10-20 bps higher.

But for the sake of simplicity, it is calculated here on net yield.  If the tenure of the FMP is more than a year, the growth option gives a higher yield because of the indexation benefit.

What is indexation benefit?

The finance minister has been generous enough to recognise that inflation erodes the real value of any investment. So every year, he comes out with an inflation index based on the prevailing rate of inflation.  The cost of investment is indexed by multiplying the index of the year of maturity and divided by the inflation index prevailing on the year of investment. If you have arrived at an indexed cost, then the long-term capital gain is taxed at 22.44 per cent and if you do not opt for the indexed cost, then the tax is 11.22 per cent.

How does this pan out?

Take an example of a 30-month FMP which, if launched now, will mature in June 2009. It will pass through three financial years - launch in 2006-2007 and maturing in 2008-2009. Thus, it can have a benefit of triple-cost indexation for the purpose of calculating post-tax yield. Look at the workings: Note: Cost Inflation Index for FY06-07 is 519. The assumption is that the CII for FY07-08 is 567 and for FY08-09 is 592. Clearly, the post-tax return is superior for an FMP. Simran was convinced of its benefits and was gung-ho about investing in it.  

How does one know of these plans?

As mentioned earlier, these schemes are not advertised heavily and the commission on them is low. But, the good news is that these plans are launched on a regular basis by mutual funds. You may have to badger your MF intermediary for information on them, but it is well worth the effort.