FMPs are a good option over fixed deposits for taxpayers

Investing in debt instruments (which have no exposure to equity or equity-oriented assets) has become very interesting now. Debt instruments like bank fixed deposits (FDs) are giving 9.25-10% returns for different tenures. Also, for a senior citizen, they have additional incentives of up to 0.5%.

So this is a fantastic investment option for those who do not come under the tax net as the entire amount earned as interest (say 9.5%), would be their returns.

This is even better for a senior citizen (who does not come under the tax net), as their return would potentially be higher by 0.25- 0.5%. A 10% interest is a decent return on instruments which have very low risks (bank deposits are covered by deposit guarantee insurance of Rs1 lakh).

But this does not work for people who need to pay taxes. Even if one earns 9.5% interest, the post-tax return for a normal citizen in the 30% slab is just 6.56%. See Table 1 for returns for normal and senior citizens coming under various tax slabs. That is where debt mutual fund schemes can help.

Understanding the taxation
Debt mutual funds are subject to capital gains. Any investment less than 12 months and returns from them, qualify as short term capital gains (STCG). STCG taxation is at one’s marginal tax slabs.

However, if one has opted for the dividend option, the income coming after dividend is tax-free in the hands of the investor. Dividend distribution tax (DDT) comes to 13.84%, which is paid by the asset management company (AMC). To that extent the returns are depressed. Since, it is tax-free after that, you end up paying only 13.84% as tax, albeit indirectly.

Hence, it should be evident that it is a better idea to opt for dividend option for those in the 20 and 30% slabs and growth option for those in the 10% slab.

Investments beyond 12 months attract long term capital gains (LTCG). Here, the taxation is 10% without indexation or 20% with indexation, whichever is less. Indexation concept is to enable a correction for the effect of inflation. If for instance, one has invested `100 and has got 9% returns, the actual returns are not 9% as there is also inflation (say 7%) that is eating into it. The actual returns are only 2%.

This in effect, is the principle of indexation. For multiple years, multiple (double, triple) indexation, can be claimed. The tax after indexation as mentioned earlier is 20%.  The post-tax returns worked out this way are very beneficial and way above what one can earn in a similar return FD (See Table 2 & 3). That is what makes Fixed Maturity Plans (FMPs) so attractive, which is also a debt mutual fund scheme.

What are FMPs? 
FMPs are 100% debt instruments which invest in commercial paper (from corporates), certificate of deposit (from banks), securitised debt, bonds, money market instruments etc. These come from different sources and have differing rates and risk profiles. Though most of these instruments have fixed interest rates, they are traded and hence there can be volatility. To take care of this, FMPs are now mandated to invest in instruments which mature on or before the maturity of the FMP itself. This takes care of the interest rate risk.

Also, to play safe and compete effectively with FDs, many FMPs that come in today have exclusive bank CD portfolios. For the purpose of understanding, it is sufficient to know that bank CDs are fixed income instruments issued by banks that give a specific return, much like an FD. Hence, a full CD portfolio is being put together these days, in many cases, to give that extra comfort to investors.

Portfolio and returns
There is one small problem. As mandated by SEBI, AMCs are not allowed to disclose either the portfolio or the indicative returns. This, they have done to ensure that an investor is not led down the garden path by showing one portfolio and the concomitant returns and actually investing in a different portfolio. However, this is actually a serious problem today for the investor.

They neither know the portfolio nor the returns. How are they supposed to invest? They would need to divine from the way the AMCs have been investing in their past FMPs and form an opinion of the portfolio construction principles generally used. They will then have to find out the returns they could expect from such a portfolio, based on publicly available information. They would also probably need to get information from others who are better informed than them (informal channels) and get clarity before investing.

Tenure
FMPs have another attraction for investors. These are not very long duration products like NSC, KVP or PPF. FMPs can even be for three-month duration. It normally starts from six months and the more popular tenures are around one year to 15 months duration. There are also FMPs which are of 18 months to three years durations. Hence, these products are available for convenient terms. Investors can invest based on their comfort, in an appropriate tenured product.

No wonder FMPs have found favour with those who have understood their unique value proposition.  Since these are close ended products, one can invest only when it comes up for subscription. FMPs may be available for subscription for a limited number of days only, which is one of the principal inconveniences. One can of course invest in a liquid or money manager fund and wait for an appropriate FMP to transfer to as an alternative.  Most AMCs offer this product. Hence, there is no dearth of choices. Make merry when the season is on.

The writer is a certified financial planner who runs Ladder 7 Financial Services and can be reached at ladder7@gmail.com