by NANDKUMAR SURTI
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It was May 11, 2006, when the BSE Sensex touched an all-time high of 12,671. Since then the equity markets have turned volatile. Investors are now waiting for markets to find a direction. In this scenario, they are looking for avenues which will preserve their capital and give reasonable returns and liquidity.

In a rising interest rate scenario, debt schemes like income and gilt funds, are prone to interest rates risks. Thus, investing in these may reduce returns. When interest rates rise, prices of a fixed-income instrument fall, as the price of a bond is inversely related to the interest rate. Given this scenario, there is a search for alternative avenues, like bank fixed deposits (FD) or fixed maturity plans (FMPs). The main difference between a bank FD and an FMP is that the amount invested and the rate of return is guaranteed whereas returns and capitals on FMPs are not assured.

FMPs are essentially close-ended schemes with a fixed maturity date. The maturity varies from 15 days to five years. These are close-ended, in the sense they remain open for subscription for a specific period. In case an FD is broken, the bank levies a premature withdrawal charge. Similarly, in the case of FMP, investors are expected to stay invested through out the plan's tenure. If an investor has an urgent need to withdraw from FMPs, a high exit load is charged. One needs to check the load structure before investing.

FMPs invest mainly in high-rated bonds, government securities and other money market instruments. Fund managers try to match the tenure of these instruments with the tenure of the scheme. For instance, an FMP of 90 days will invest in the instruments maturing closer to 90 days. Thus, by investing in the specific maturing instruments, fund managers mitigate interest rates risk on the portfolio. Also, investment in high-rated instruments reduces credit risk on the portfolio. Investments in these instruments generally provide better returns than a bank FD and, therefore, attract risk-averse investors.

FMPs are also tax-efficient. Investments held for less than a year would be taxed at a short-term capital gain tax and investments held for more than a year would be taxed at a long-term capital gain tax rate, with the benefit of double indexation (indexation is the process by which inflation is taken into account when computing tax liability). Short-term capital gains arising to a unit holder will be taxed at the normal rate applicable as per the provisions of the Income Tax Act. Surcharge and education cess on the above rates are as per the income tax rule.

Like other MF debt schemes, dividend from an FMP would be subject to dividend distribution tax. MFs are required to pay distribution tax on income distributed (dividend) by it at the rate of 14.025% in the case of distribution to individuals and Hindu Undivided Families (HUFs). An increased rate of 22.44% is applicable for distributions made to persons other than an individual or a HUF. Interest on a bank FD is taxed at the normal rate applicable to that investor (33.66% tax rate for an individual investor in the high tax rate slab). As such, choosing a dividend plan for investment below one year and growth plan for investments above one year enables one to save around 10–20% on tax liability, depending on whether the unit holder is an individual or a corporate.

In a rising interest rate scenario, interest rates on short-term assets keep rising. Thus, by investing in short maturity plans, investors can take the benefit of reinvesting at higher rates after the maturity of an earlier scheme. In the process, they can eliminate reinvestment risks. Long-tenure FMPs are generally chosen to derive the benefit of lower taxation and indexation benefit.

In sum, I would say when equity markets are struggling to find their ground and rising interest rates are making income schemes riskier, FMPs are providing a safe haven for short-term investors who are looking for fixed-income avenues.

Happy investing!

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The writer is CIO, Debt Lotus India AMC



Tags: avenues, capitals, liquidity, fund managers, tenure, credit risk, rate of return, maturity date, fixed income