'Fix' your debt fund, give tax a miss

Towards the end of the financial year mutual fund houses go into an overdrive to launch fixed maturity plans (FMPs), which are essentially close-ended income funds. Close-income funds have a fixed maturity period and investors cannot enter or exit the fund in the interim. They hope to target investors who typically park their money in fixed deposits.

FMPs score over FDs due to lower taxation. Debt fund returns can be adjusted against inflation, which is the indexation benefit. This effectively reduces the tax outgo. By investing in an FMP just before the financial year end you can enjoy indexation benefit for longer period than the tenure of the fund. Let us see how.

Why invest now

If you invest in a 40-year FMP now, that is one which has a maturity tenure of a little over three years, you will effectively get indexation benefit for five financial years (Indexation is the process by which the value of an asset is adjusted against the inflation rate. This will bring down the value and thereby the taxes to be paid on the gains). From 2018-19, the year in which you invest in the FMP, till 2022-23, when it matures, even if you are holding the FMP only for a few days in both these financial years. And this will effectively ensure almost nil capital gains thanks to indexation benefit, points out Amit Jain, co-founder Ashika Wealth Advisors. "That is the reason why mutual funds launch FMPs during the second half of the March. The indexation benefit is a huge advantage,'' he says.

Vidya Bala, head - mutual funds research at FundsIndia, says it is usually a practice that fund houses tend to launch FMPs during the year-end because investors can get indexation benefit, especially if it crosses three years. "If you put money now in an FMP, it is counted as being invested in 2018-19, so it is counted as 2018-19, 2019-20 and 2020-21. Even if you hold it till April 2, 2020, it will still be counted as three years and you will get three years indexation benefit. It makes a huge difference,'' she says.

Jain says with a five-year indexation benefit the taxation is almost nil, and that is why FMPs score over bank FDs, which are taxed at your slab rate.

"Assuming a bank FD is offering 8% and FMP is offering 8.5%. Post-tax the FD will give a return of 5.6% (for someone in the 30% tax bracket) while FMP will offer 8.5%," he says.

But since inflation is currently low, investors need to invest in longer term FMP of at least five years to ensure no tax.

"The indexation benefit is not as much as earlier, with inflation going down. Now you need to take five years indexation to get low or nil taxation,'' says Jain.

But despite the lower inflation, the indexation benefit is still attractive for someone in the 20 or 30% tax bracket, points out Bala.

Be aware of credit risk

Investors have to be careful about credit risk, especially since FMPs are close-ended funds and there is no opportunity to exit the fund before maturity. Hence, one must check the scheme information documents to understand what kind of investments the scheme will invest in. "Investors must check what proportion of the fund is invested in 'AAA' or 'AA+' rated papers and so on. That will give you a decent indication of the kind of risk that you are going for,'' says Bala.

Investors tend to overlook the credit quality, says Dhaval Kapadia, director-portfolio specialist, Morningstar. "Over the last five to six months debt funds have faced a lot of challenges. Whether it was the IL&FS issue or the stress in the NBFC sector. One has to be mindful of it when looking at FMPs,'' he says.

Fund's tenure should match your investment horizon

Another condition to keep in mind is whether the tenure of the FMP aligns with your investment horizon. "Be clear about this because there won't be any exit option from the fund house during the tenure of the FMP. So ensure that your horizon is aligned with the tenure of the FMP,'' says Kapadia.

At the current juncture if you have a choice with three- and four-year kind of horizon you can ideally lock into a three-year kind of FMP.

"With inflation coming off and global central banks, particularly the US Fed having changed its stance of not raising rates, there is a likelihood that interest rates could come down in India too. We have seen the first rate cut and now with growth slowing globally and domestically, chances of a rate cut are higher. So if you have a three or four year investment horizon, you can ideally lock into a three-year FMP,'' says Kapadia.

Open-ended income fund versus FMP

An FMP will let you lock in rates, while in an open-ended income fund, it depends on the fund manager's view of interest rates. An open-ended income fund has no fixed maturity period and investors can enter or exit the fund anytime. "In FMP as long as credit quality is sound, you know that this is the return you should expect. You won't be able to do that in an income fund. For retail investors, getting in and out of the income fund may not be feasible. In short-term funds you can be a little more confident that interest rate risk is relatively lower. But the expense ratio tends to be higher in an actively managed fund, while FMP is a passive fund and hence expense ratio is lower,'' says Kapadia.

Although cost is a benefit for FMPs, the disadvantage is that money is locked for three years or more. "Even if you find a good opportunity to invest, you cannot withdraw the money. While in case of income fund you have the advantage that whenever you can redeem whenever you want to by paying the exit load and invest it another investment,'' says Jain.

However, that can be an advantage too. According to Bala, "If you are an active investor who likes to monitor investments and values liquidity, then open-ended is a good option. Those who like to remain passive and believe that FMPs will give discipline because they cannot exit even if they want to due to volatility can can invest in FMPs,'' she says.

Hence, a passive investor who does not track the market and does not worry about volatility and does not want the money till maturity can invest in an FMP. "But if you are doing it as part of your long-term wealth creation, along with equity funds, you should consider open-ended funds as they offer similar indexation benefits,'' Bala says.