What Are Fixed Maturity Plans & Double Indexation Benefit
Many of us think that fixed maturity plans (FMPs) and bank fixed deposits are almost the same. The basic similarity between FMPs and bank FDs is that both of these products are close ended and have a definite maturity date. The below article provides an in-depth analysis of what FMPs are.
Closed-ended & pre-specified period
FMPs are closed-ended mutual fund schemes, with a pre-specified tenure. FMPs are usually offered for tenures varying from 30 days to five years. The most commonly offered tenures are 30 days, 180 days, 370 days and 395 days.
As said earlier, FMPs are somewhat similar to bank FDs, in that the money invested is locked in for the tenure of the scheme. FMPs are debt funds that invest in government securities and company debt. FMPs typically have no equity component, unless you invest in an FMP that chooses to have a limited equity component.
The basic objective of FMPs is to seek steady returns over a fixed period, aiming to protect investors against market fluctuations. Being close ended funds, FMPs offer flexibility to their fund managers and let them plan on their exact investments at the NFO stage. As a result, investors can know in advance about the approximate yields they can get by investing in these FMPs at the NFO stage.
FMPs are ideal for all investors wanting benefits across different parameters, such as lower market risk and tax efficient returns.
Features of FMP
Investors can choose the FMPs that match their investment horizon and their cash flow requirements.
FMPs invest in fixed income instruments like certificate of deposits (CDs), commercial papers (CPs), other money market instruments, corporate bonds, non-convertible debentures (NCDs) of reputed companies, or in securities issued by the government, maturing in line with the tenure of the scheme.
Closed ended funds
Since FMPs are closed ended schemes, an investor can invest only during the initial offer period of the scheme, and redeem only at the time of maturity of the respective series under the scheme. However, unit holders holding units in demat mode, can exit by selling their units on the stock exchange where units of an FMP scheme are listed.
Low interest rate sensitivity
FMPs are least exposed to interest rate risk, as the fund holds instruments till maturity-getting a fixed rate of return.
Low credit & liquidity risk
FMPs generally invest in highly rated credit instruments with maturity profiles of the invested securities in line with the maturity of the scheme, so there is low credit risk, with minimal liquidity risk involved.
FMPs, as asset allocation tools, are market neutral products that endeavour to provide the investor with stable returns for the period of investment. Hence they find takers across the investor base spectrum.
FMPs score over fixed deposits because of their tax efficiency. In FMPs, longer than a year, investors may choose to avail indexation benefits to rationalise their taxable liability against prevalent inflation for the period.
Current relevance of FMP
The rate cycle seems to have peaked, as inflation and growth data have started trending down.
In an environment of high prevailing rates, and with other asset classes not adequately performing, it makes sense for investors to invest in FMPs which endeavour to lock in returns by investing in instruments maturing on or before the maturity of the scheme.
FMPs are an ideal platform to capitalise prevailing high yields, without assuming the volatility risk of investing in a duration product.
Taxation: FMPs vs bank FDs
FMPs are usually tax efficient. Here is a simple tax calculation that demonstrates the tax efficiency of FMPs vs FDs.
For a one-year FMP, the tax works out to 10% without indexation and 20% with indexation. Indexation benefit for FMPs are high, since the inflation rate is high, as a result, you may have to pay less tax for an FMP. For example, if you invest Rs. 10 lakh in a one-year FMP, and assume the FMP gives a return of 9%â€”Rs. 90,000. The applicable tax rate in the highest tax bracket (plus 3% education cess) would be 10.3%. The tax liability without indexation would be Rs. 9,270. Hence the total amount received (net of tax) would be Rs. 10.8 lakh. The post tax return for investment period of 12 months would be 8.07% per annum.
Assume you avail indexation benefit which is 7% rate of inflation index. The applicable tax rate for the highest tax bracket is 20.6% (20% tax + 3% education cess). The tax liability with indexation would be Rs. 4,120. Therefore the total amount received (net of tax) would be Rs. 10.85 lakh. The post tax return for investment period of 12 months comes to 8.59% per annum.
On the other hand, a bank FD doesnâ€™t offer indexation benefit and the applicable tax in the highest tax bracket including cess is 30.9%. The FD offers an interest rate of 9% pa. Therefore your tax liability would be Rs. 27,810. The total amount received (net of tax) would be Rs. 10.62 lakh and the post-tax return for the investment period of 12 months is 6.22% pa.
FMPs, however, are not allowed to provide â€œindicative yieldsâ€ to investors while in FDs the interest rates are pre-defined.
Returns from FMPs are subject to tax as follows:
If investors opt for the â€œdividendâ€ option (returns are received as dividends), they are subject to dividend distribution tax (DDT) @ 12.5% (for retail investors) plus applicable surcharge and cess, which is paid by the fund and is tax-free for investors.
If investors opt for the â€œgrowthâ€ option, they are subject to capital gains tax. For example, in case of a growth option with a maturity of more than one year, an individual can use the benefit of long term capital gains where the tax rate is 10% (without indexation benefits) or 20% (with indexation benefits).
For FMPs with tenure of less than a year, the dividend option is more appropriate as it results in lower tax incidence compared to the growth option, which would be taxed at individual income tax slab rates.
Double indexation benefit
FMPs also offer double indexation benefit, which comes into play when the scheme purchase is made in one financial year and the maturity of the scheme is after two financial years. Indexation (for tax purposes) allows returns generated on FMPs to be adjusted for inflation so that investors are taxed only on the real returns.
For instance, if a 13-month FMP is launched in March 2010 i.e. FY09-10, it will mature in April 2011 i.e. FY11-12. While the investment is made in FY09-10, the redemption takes place in FY11-12. Thus, by investing in FMPs with maturity of a little over a year, the purchase and sale years are spread over two financial years, called double indexation, which effectively reduces oneâ€™s tax liability.