I Came across this note in Economic times about FMP’s and have reproduced it here. It gives a fair idea about FMP’s in general and the advantages/disadvantages of investing in them along with Indexation benefits. There are some obvious benefits of investing in FMP’s over FD’s in terms of post tax returns using the indexation benefits. Investing towards the end of March gives double indexation benefits as well.
A fixed maturity plan (FMP) is a closed-ended debt scheme, wherein the duration of debt papers is aligned with the tenure of the scheme. So a one-year FMP will invest in debt instruments that mature in one year or just before this period.
This synchronized maturing completely eliminates the interest rate or reinvestment risk.
The FMPs invest largely in certificates of deposit (CDs), commercial papers (CPs), money market instruments, corporate bonds, even in bank fixed deposits. Though the yield of these wholesale debt papers is slightly higher than that of the retail FD rates, FMPs charge fund management fees and, therefore, the final return for investors is more or less close to the retail FD rates.
So why should one consider the FMPs?
While such plans offer several advantages, the tax benefits stand out. Irrespective of the holding period, FMPs generate better post-tax yield. The length of the holding period matters, especially when one has to decide between growth and dividend options. Investors can go for the growth option if the holding period is more than a year, and for the dividend option if the holding period is less than a year.
Mutual fund investors have the option of paying capital gains tax at 10.3% (without indexation) or at 20.6% (with indexation). Indexation helps offer compensation against the rising inflation and, in this case, one is allowed to increase the value of initial investment as per the cost inflation index provided by the Income Tax Department. On the assumption that the inflation is 6%, the capital gain after indexation works out to just 4%. Since the 20.6% capital gains tax is paid only on 4%, the effective is lesser, taking the post-tax yield up to 9.18%.
As per the current law, investors can claim double indexation benefit if the holding period is over three financial years. Consider the case of a 375-day FMP, which starts on 26 March 2012 and matures on 5 April 2013. Since it is spread over three financial years-2011-12 (investing year), 2012-13 (holding year) and 2013-14 (redemption year)-the indexation will be for two years (6%+6%). In this case, one can report a 2% long-term capital loss (instead of gain) and it can be set off against other long-term capital gains reducing the tax liability further. One can come across several FMPs with double indexation benefits in March.
Though FMPs offer several advantages, investors should also be aware of the drawbacks. Unlike the bank FDs, where one can opt for premature withdrawal by paying a small penalty, the exit from a fixed maturity plan is very difficult. Though these units are listed on the stock exchanges, most counters are virtually illiquid. Even if random trade takes place, it is usually at a discount to the NAVs. So investors should put in only the money they don’t need till the maturity of FMPs.
Though the FMPs are relatively less risky, investors should not treat these as dream products that offer high return with zero risk. While the structure eliminates interest rate and reinvestment risk, the credit risk (or the default risk) still exists. Since the fund houses are not allowed to give ‘indicative portfolios’, there is no mechanism to make sure that the money will be invested only in high quality papers. While bank FDs come with deposit insurance (for a holding of up to Rs 1 lakh), a similar facility is not available for FMPs. So one should only opt for reputed fund houses. ~ Source ET