Lest you forget, it’s the FMP season again

With a host of offerings up for the grabs, you must at least know what the products stand for

It’s the season of fixed maturity plans (FMPs). There are essentially two factors in favour of FMPs at present. One, of course, is on account of the fact that to keep a check on inflation, RBI has steered clear of cutting interest rates, thereby giving an opportunity to investors of locking in high yields. Secondly, investing in FMPs during the last week of March gives rise to the tax planning mechanism of double indexation.

Today’s article explains this tax planning strategy in detail, but first, let us understand what FMP is all about.
FMPs are essentially closed-ended income schemes with a fixed maturity date, i.e. they run for a fixed period of time. This period could range from 15 days to as long as two years or more. Just as in a fixed deposit, the scheme matures when the period comes to an end and your money is paid back to you.

Need for FMPs
Traditional income funds carry a risk known as ‘interest rate risk’.

Interest rates and prices of fixed income instruments share an inverse relationship. In other words, when the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa. Adjusting the portfolio to the market rate of returns is called ‘mark to market’. In simple words, when interest rates in the economy rise, the net asset value of an income fund falls and vice versa.

FMPs effectively eliminate this interest rate risk by employing a specific investment strategy. FMPs invest in instruments that mature at the same time as the maturity date of their schemes. So, a 370-day FMP will invest in instruments that mature exactly in or within 370 days. Holding the underlying instruments up to their maturity effectively mitigates the interest rate risk as there is no buying and selling of the instrument needed.
However, note that though the return is more or less certain for the fund manager, these are not assured return schemes. The returns could at best be indicative.

Tax impact
For all practical purposes, an FMP is an income scheme of a mutual fund. Hence, the tax incidence would be similar to that on traditional income schemes. Redemptions from investments held for less than a year will be short-term gains and added to the investor’s income to be taxed at the slab rates applicable. If such investment is held for more than a year, the long-term gains would be taxed at 20% with indexation or at 10% without. These rates are subject to the surcharge and education cess as normally applicable.

Double indexation
Double indexation is a neat trick where you hold an investment for a little more than one year, but get the benefit of the index multiple of two years. How is this done? The table below explains this concept with the example of a 370-day FMP.

FMP - 370 days
 Investment date March 29, 2008
 Investment amount Rs10,000
 Yield 9.50%
 Maturity date April 3, 2009
 Value at maturity Rs10,964
 Cost Inflation Index
 (CII) for FY 07-08 551
 CII for FY 09-10
 (assuming 5% inflation) 607
 Indexed cost of acquisition
 (Rs10,000 * 607 / 551) Rs11,016
 Long-term capital gain (Rs53)
 Tax thereon (Rs11)
 Net cash flow Rs10,964
 Annualised returns 9.50%

The FMP is for 370 days, exactly 5 days more than one year. However, check out the date of investment and date of exit. The entry date is March 29, 2008, i.e. FY 07-08. The date of sale is April 3, 2009, i.e. FY 09-10. By holding the investment a little into the next financial year, an investor can use the facility of the CII for two years. The rest of the table is self-explanatory. The CII usage boosts the cost beyond the sale price due to which the investor suffers a notional capital loss. Consequently, the entire maturity value is rendered tax-free. The net annualised return remains at 9.50% without any tax incidence whatsoever. On the other hand, a 9.50% pre-tax yield on a bank deposit would have fallen to 6.65% after the 30% tax.

To sum
But, you might still wonder if the FMPs are meant for you.

Well, with the stock market poised the way it is right now, many investors may wish to park their funds in a safer asset class. Secondly, every investor, irrespective of whether he or she is aggressive or risk averse, will have a certain percentage earmarked for fixed income investments. FMPs provide an additional option on the fixed income front. Or perhaps, you have some money in hand that is required at a later stage and can be temporarily parked somewhere safe and gainful.

The point I am trying to make is, no matter what the situation, a product like the FMP always comes in handy. Provided you know about it, of course.

sandeep.shanbhag@gmail.com