With the stock markets gyrating up and down, many investors may prefer to wait out the storm 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 stands 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 fifteen days to as long as two years or more.

For instance, in a fixed deposit, when the period comes to an end, the scheme matures, and your money is paid back to you.

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 depend on the tenure of the scheme.

The 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 an economy rise, the NAV of an income fund falls and vice versa.

FMPs effectively eliminate this interest rate risk. This is done by employing a specific investment strategy. 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.

However, note that though the return is more or less certain for the fund manager, these are not assured return schemes. The returns could be at best indicative.

Liquidity

Most MF schemes return your money within 5 days. However, the structure of a FMP does not lend itself to this kind of liquidity. Invest money you are more or less sure you will not need during the tenure of the plan.

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, as the scheme opens for subscription, the tenure (whether 15 days, 30 days, 180 days etc.) 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.

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. 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 is held for more than an year, the long-term gains would get taxed at 20 per cent with indexation or at 10 per cent without. These rates are subject to the surcharge and education cess as normally applicable.

Are FMPs for you?

As I write this, markets are swinging wildly. Depending upon who you talk to, there are views that either a more severe correction is round the corner or the market is going to consolidate Though no one has seen what tomorrow has in store, common sense says that committing all of one's funds at such a time is fraught with risk.

It is better to invest with a slow and steady approach and put the bulk of your investible funds in a safe but liquid avenue. But the problem with fixed income is that an investor has few options to choose from.

With Finance Act 2005 withdrawing Sec. 80L, all fixed income instruments have become fully taxable. If you belong to the 33.66 per cent tax bracket, after paying tax, the left-over return may be hardly enough even to cover inflation. Plus there is the lock-in factor to contend with.

Tax Arbitrage

FMPs provide an arbitrage opportunity as far as the tax rate 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 14.025 per cent, 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 @22.44 per cent is lower than the maximum marginal rate.

Even for the growth option, a tax of 10 per cent 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. How this can be done will be presented in terms of illustrated examples next time.

To Sum Up

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.

The author is the director of A N Shanbhag NR Group, a Mumbai based tax and investment advisory firm. He may be reached at sandeep.shanbhag@moneycontrol.com

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