Fixed Maturity Plans better than Bank Deposits

This article is specific to india and Indian tax laws.

Mutual Funds are allowed to launch Fixed maturity plans (FMP) which by their name shall be clear to investors. The maturity, whether 1 month or 1 year shall be made very clear to investors in the offer document of the Mutual fund along with the indicative returns expected. (FMP) are closed-end debt funds that aim at generating returns that are indicated at the time of launching the scheme. Mutual funds are not allowed to launch assured return schemes. FMPs, therefore, only indicate the likely returns. FMPs can generate predefined returns because of the way their portfolio is constructed. They invest in debt securities which mature around the tenor of the fund. Since the instruments are held to maturity, there is no risk of the value of the security being affected by interest rate movements and fund managers are able to give returns indicated at the time of investing.
FMPs come with various maturities at which time the money with the returns are credited back into the investor’s bank account. The popular tenors are of one month, three months and a little over a year. As closed-end funds, FMPs cannot accept any fresh investment once the NFO is over. To help investors deploy their available funds and reinvest money from maturing FMPs, mutual fund houses launch a continuous series of FMPs. The NFO is usually open for two to three days and the minimum investment is kept at around Rs 5,000. Since investors cannot withdraw their money till the maturity of the scheme, they need to choose a fund with a tenor that matches their investment horizon.

Why FMP?
FMPs are similar to bank fixed deposits (FD) in features such as fixed maturity period and indicative return. But they do not guarantee returns like FDs do.

So, why should an investor choose an FMP over an FD?
The answer lies in the tax efficiency that FMPs bring to their returns.
a) The example given in the table below shows that while FMP attracts the dividend distribution tax (DDT), FD attracts income tax. Since DDT is lower than the income tax rate, FMP gives a higher post-tax return than FD.
b) FMPs with maturities of greater than one year provide capital gains efficiency by structuring the tenor in such a way that investors benefit from double indexation. For example, an FMP holder holding the FMP launched on 30 March 2007 for a little more than a year (375 days) till it matures on 9 April 2008, an investor gets to use the cost of inflation index applicable for the years 2006-2007 (year of purchase) and 2008-2009 (year of redemption). The tenor of the fund and the date on which it is launched allows double indexation, thus reducing the capital gains tax applicable on the returns.
FMPs suit investors who have a fixed investment horizon and would like to know the likely returns. The tax advantages make them superior to FDs. The only caveat is that investors need to evaluate the credit risk involved in the securities that the FMP is likely to invest in.

FD vs FMP: Effect of Taxation

FD FMP
Investment (Rs) 5,000 5,000
Rate of interest (% p.a.) 9 9
Amount at the end of 1 year (Rs) 5,450 5,450
DDT1 (%) ( Div Distbn Tax ) Nil 14.1625
Tax on interest (%) ( Income Tax rate) 33.66 Nil
Net amount2 5,298.53 5,386.28
Post-tax return (%) 5.97 7.72

1Dividend distribution tax
2Assuming the FMP distributed the entire Rs 450 as dividend

From the above example it is clear that
- Even if an investor holds an FMP less than a year, he/she is better off in the post tax yield. The above example shows that the FMP yield is 7.72% vs the FD yield of 5.97% for an investor in the highest Income tax slab of 33%.
- If the Investor holds the FMP for 375 days as mentioned in b) above, that is between 30th March 2007 till 9th April 2008, then only an indexed capital gains tax apply. The steps to arrive at the tax is as below.
- First find out the indexation factor. Assuming the inflation index for 2006 -07 is 100, for 2007-08 it is 105 and 2008-09 is 110. The indexation factor for this investment is 110/100 which is equal to 1.1.
- Then multiply the actual investment with the Indexation factor. In this case, it is Rs 5,000 multiplied by 1.1 which shall be Rs 5,500/-.
- Now look at the actual return provided for 375 days at the rate of 9% for 365 days. It is approximately Rs 450.
- Calculate the total principal plus interest and subtract it from the indexed investment. This is the gain received. Which is Rs 5450( total receivable) minus Rs 5,500 (indexed cost ). Which is minus Rs 50. As there are no gains, the capital gains tax of 20% on gains need not be applied. So, the post tax yield in this example is 9% vs the post tax yield of 5.97% the FD yields.

Hence, be wise – always invest in FMPs offered by Mutual Funds as against the bank FDs. If you hold it for above 365 days ( across 2 financial years) , the returns are still better.

Disclaimer: These are just my views and the readers are advised to consult their financial advisors before making any investments. The readers indemnify this author against any and all eventualities which may or may not occur in the financial markets. Also, tax illustrations if any are applicable only when this article was posted and they may change subsequently thereby making any tax adjusted return calculation different.