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Gradually, FMPs fall out of favour

Being close-ended funds, their new fund offers are open for subscription for a limited and one can only invest in them during that period. Also, an investor can redeem them only on maturity.

June 20, 2015 11:44 IST | India Infoline News Service
FMPs are short-term, closed-ended income schemes of mutual funds, which invest in income instruments or debt securities with maturity coinciding with the maturity of the scheme, such as such as treasury bills (T-bills) commercial papers (CPs), certificates of deposit (CDs), and government and corporate bonds.
 
Being close-ended funds, their new fund offers are open for subscription for a limited and one can only invest in them during that period. Also, an investor can redeem them only on maturity. However, units of FMPs are usually listed on stock exchanges and one can sell them to other investors on the exchange.
 
These funds were immensely popular among corporate clients and high networth individuals as they provided an attractive alternative to bank deposits for parking funds in the short term. However, a little tweaking of the tax rules in connection with this product in the interim budget in June last year, these funds have seen outflows of about Rs 50,000 crore. 

The new rule requires an investment to be held for at least three years in order for it to be eligible for availing tax benefits. Average yields of FMPs have since fallen to around 9 per cent from a high of 10.25 per cent in 2012-13. The downward trajectory in interest rates also took the sheen off these products.

Ever since the tweaking of the tax rules, fund houses have started rolling over the maturity of their schemes from one year to three years, in order to avail tax benefits. Earlier, these funds were either subject to short-term capital gains tax as per one’s tax slab if redeemed within a year or faced long-term capital gains tax if redeemed after a year. 

Rollovers are beneficial to investors in the 30 per cent bracket. Those in the 10 per cent bracket, on the other hand, can benefit by exitting as they are not impacted much by the change in rules. Investors in the 20 per cent bracket choosing to roll over will be impacted marginally, to the extent of the indexation benefit. 

In the second instance, they were taxed at 10 per cent without indexation or 20 per cent with indexation. The indexation benefit inflates the cost of purchase lowering long-term gains tax liability, hence due to indexation benefit, FMPs ended up becoming more tax efficient than a bank fixed deposit, particularly for investors who are in the 20 per cent or 30 per cent tax brackets. 

Beside the holding period, the tax implication also depends on the investment option -- whether dividend or growth. Dividends in FMPs are tax free in the hands of investors. However, mutual funds companies pay a dividend distribution tax before distributing it to investors. In the growth option, the returns earned are treated as capital gains, short-term or long-term depending on tenure of investment. 

While theoretically the product still looks attractive, but FMPs usually do not do well in a falling interest rate environment, which is why these funds have fallen out of favour with investors over the past few months.

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