If you have money that you do not need for a specific period but you don’t want to take a lot of risk with, an FMP or a fixed maturity plan might just be your answer. These are funds which invest in relatively low-risk debt securities with a specific time-frame in mind. With rising bond yields playing havoc with the returns of long-term debt funds, an FMP might well be a smarter choice. Why? We explain below
What is it?
As the name suggests, FMPs are debt mutual funds having a fixed maturity period. Hence, they are close-ended. This means that you can invest in them only during their offer period and can get back your money only at the end of the maturity period. FMPs are often considered as an alternative to fixed deposits. These schemes invest in debt market securities and are considered to be safer than equity mutual funds and some other debt funds.
Interest Rate Protection
Usually, FMPs invest in securities that are in line with the maturity period of the fund. This helps the fund to avoid interest rate fluctuations. Interest rate fluctuations have sharply brought down the returns of long-term gilt funds and income funds over the past year to 1.65% and 4.48% respectively.
So, which of the securities do FMPs invest in? These are a wide-ranging basket including government securities like treasury bills and bonds and corporate borrowing through non-convertible debentures (NCDs), commercial papers (CP) and other debt market securities.
One of the reasons why FMPs are popular is because of the tax benefits they offer as opposed to fixed deposits. Unlike an FD where you are taxed as per your income tax slab, you can take advantage of the indexation benefit in case of FMPs.
What is indexation? How does it help?
When you have held your FMP for more than three years and redeem it for some gains, the gains will be termed as long-term capital gains. The tax rate for such long-term capital gains is 20% with indexation. Indexation allows you to determine the cost of your investment at today’s rate rather than taking into account the cost at which you made the investment. Let’s take an example to understand this better.
Suppose you invested Rs 1 lakh in FMPs on 20th July 2012 and the FMP matured on 21st July 2015. Let’s say that the annual return from this FMP was at 9% per annum. So, the maturity value is about Rs 1.3 lakh. If you don’t take indexation into account, your capital gains will be close to Rs 30,000. If you use the indexation benefit, you will calculate how much that Rs 1 lakh will be worth in 2015 when you sell the fund.
This helps you take into account, the inflation in the country and you will be paying taxes only on the real returns.
The formula for calculating the indexed cost of your investment is the cost of purchase x (index value for the year of sale/index value for the year of purchase). The index used here is the Cost of Inflation Index. This will tell you the true value of the investment that you made. When you use the indexation formula, you will get the indexed cost of investment as Rs 1.26 lakh. Now, you should subtract the indexed cost from the maturity value of your investment to get the capital gains. So, you would get Rs 1.3 lakh minus Rs 1.26 lakh, which is about Rs 4,000. You would pay just about Rs. 1,000 as taxes.
If you had invested in an FD, you would have to pay over Rs. 9,000 as taxes assuming that you are in the highest tax bracket!
FMPs don’t require you to invest substantial sums of money. Minimum investment usually ranges between Rs 5,000 and Rs 10,000. The tenures offered also have a wide range and are usually between 15 days and 5 years. You can choose the FMP that suits your budget and time range.
Most FMPs invest in highly rated securities (read AAA). You can check the securities that the FMP is planning to invest in before choosing one.
Your FMP is falling short of the three year period and you can’t take advantage of the indexation benefit? Then, you can check with your fund house if they will provide a rollover for your FMP – meaning the period gets extended. In case you don’t need the funds urgently, you can consider rolling over your FMP.
Just like a tax-saver FD, FMPs are not liquid. They are listed on stock exchanges but are not actively traded. So, exiting the FMP before maturity might not be easy. Keep this in mind while investing in FMPs.