The Way to Overcome Rising Interest Rate Risk

With the stock markets are volatile; many investors prefer to wait and re-enter when the going gets smooth again. Meanwhile, there is need for a temporary parking place for funds where capital is guaranteed and the return is reasonable. At the same time, there should be ample liquidity, as the money could be needed anytime when there is a buying opportunity. FMPs offered by mutual funds are the apt solution for such a need.

What is an FMP?

FMPs stand for Fixed Maturity Plan. These are essentially close-ended income schemes with a fixed maturity date i.e. that run for a fixed period of time. This period could range from 1 month to as long as two years or more. Just like an income scheme, FMPs invest in fixed income instruments i.e. bonds, government securities, money market instruments etc. The tenure of these instruments depends on the tenure of the scheme.

The need for FMPs

Interest rates and prices of bonds share an inverse relationship. In other words, when the interest rates in the economy rise, the prices of bonds 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 an economy rise, the NAV of an income fund falls and vice versa.

FMPs effectively eliminate this interest rate risk. FMPs invest in instruments that mature at the same time their schemes come to an end. So a 90-day FMP will invest in instruments that mature within 90 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.

Liquidity

The structure of a FMP does not lend itself to liquidity. You can only withdraw the money during pre-set time periods. It is not an open-ended fund that allows you to exit (sell your units) whenever you want. Further, during the NFO, the tenure is declared. So investments may be made for a suitable tenure. If money is urgently needed, most FMPs will charge you a steep exit load. Do check the load structure before investing. The reason for this steep load is to deter investors treating the FMP like a normal income scheme. As already mentioned, though income schemes invest in similar instruments as an FMP, being open-ended and not having a specific tenure based investment strategy, these are subject to interest rate risk.

FMP is primarily a debt product and so, the tax incidence would be similar to that on traditional debt schemes. The dividend from an FMP will be tax free in the hands of an individual investor. However, it would be subject to the dividend distribution tax. 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 slab rates applicable. If such an investment were held for more than a year, the long-term gains would get taxed at 20% with indexation or at 10% without. These rates are subject to the surcharge and education cess as normally applicable.

FMPs provide an opportunity as far as the tax saving is concerned. You may belong to the highest tax bracket but the distribution tax that is payable by the MF on the dividend is fixed at 14.16%, which is much better than paying tax at the highest rate. Corporates too indulge in tax arbitrage by investing in FMPs, as the distribution tax rate applicable to them @22.66% is lower than the maximum marginal rate. Even for the growth option, a tax of 10% on the gains will work out fiscally much more advantageous than the traditional tax rate. Plus a strategy popularly known as double indexation can also be used.

Hitherto, on account of the rising interest rate environment, income schemes were not a safe bet for investors. The advent of FMPs has changed all that. Therefore, if you are looking for a fixed income avenue that yields a reasonable return with minimum risk, adequate liquidity and tax efficiency, FMPs will provide you an effective shelter.
Source by Mahesh Mohan

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