Want better post-tax yield? Go for Fixed Maturity Plans (FMPs)

While investing in bank fixed deposits, it is very much sure that you have fed up with your post-tax interest income as the income tax eats up such a large chunk of your interest income. Because, interest received from FDs is subject to tax at the investor’s marginal rate of tax, which can range from 10.30% to 30.90%. It is obvious that you would be looking for an option that is low on risk and getting high post-tax returns. Choosing to invest in Fixed Maturity Plans (FMPs) would give you the perfect investment option not only to strength your portfolio but also generate better post-tax yield. For conservative investor spooked by equity market, where FMPs carry low-risk could prove to be good choice now.

Fixed Maturity Plans

FMPs are close-ended debt schemes with a pre-defined maturity date, whose primary objective is to generate equivalent bank FD returns over a fixed tenor, typically one month to five years. The maturity amount of a fixed deposit in a bank is ‘guaranteed’, but only ‘indicated’ in the case of FMP of a mutual fund. Ironically, both are not strictly comparable as one is generated contractual return whereas other is linked to market return, still they are considered no market risk, provided that it is held till maturity. Typically, FMPs invest in debt market instruments like treasury bills, bonds, government securities, money market instruments which have very short-term fixed tenures. Hence, there is no downside in returns because once the portfolio constructed, the return is locked in and not susceptible to market movement as in the case of open ended mutual funds.

FMP Taxation Aspects

In case of bank FDs, the interest is clubbed with your income and is to be taxed as per the specified slab rates; it slashes your actual earned yield subject to minimum 10% to 30% of the interest income. While in case of FMPs deliver a better post-tax return than bank deposits as they enjoy the benefit of lower long-term capital gains tax which the tax rate applicable is 10 per cent without indexation or 20 per cent with indexation for inflation whichever is low.

Given below is an illustration which elucidates the tax benefits regarding indexation in FMPs. Sample this:

Double Indexation Benefit

*Inflation rate for indexation assumed to be 8%

It is evident from the table the chief advantage of FMPs have the better tax treatment. While the short-term capital gains are taxed at the marginal rate like the interest from FDs, the long term capital gains say, for more than one year of holding are given preferential treatment. One can choose between two tax rates—20% with indexation, or 10% without indexation. Though the relevant index number for a financial year for computation of indexed cost is declared on a year to year basis, it is reasonable to assume an 8% indexation because of the prevailing high inflation.  It implies that the post-tax returns from FMPs will always be higher than those from bank FDs. While choosing FMPs, one should consider only the growth option by virtue of indexation for long-term capital gain because the dividend option has become practically redundant after the government increased the dividend distribution tax to 25%.

Double indexation: Most AMCs are currently offering FMPs with a little more than one year maturities to provide the double indexation benefit. The double indexation facility is available when the investment period steps into three financial years. Assume that you are investing March 2014 and the FMP matures on April 2015. This 13-month product covers three financial years—investment in 2013-14, holding throughout 2014-15, and redemption in 2015-16. Even with a reasonable indexation benefit of 8% per annum, the double indexation will take the indexed cost up by 16.64%, much higher than the return generated by the 13-month FMP and, hence, making it tax-free. Since, the indexation benefit is available twice in such products, popularly known as ‘double indexation’. Moreover there is bonus point of using the double indexation benefit is booking notional  long-term capital loss which can be set off against only other long-term capital gains over the next seven assessment years  and can help save tax on the future years as well.

Limitations of FMP

Since the fund is closed ended, the investor cannot exit from the fund before its maturity. The only this limitation reduces the liquidity of FMP. Though the units are compulsorily listed at the stock market, there is no liquidity in secondary market due to thin trading volume and one may be forced to sell at a discount if one needs the money. The investor should be clear about the horizon prior to making the investment decisions; in case of liquidity requirement in the interim, it would be difficult to buyer. On the interim liquidity front, there is another class of FMP that is gaining popularity of late called Interval funds. These are open ended funds that mimic FMPs that have lock-in periods of a quarter, half a year or a year with maturities on specific dates. Investments in such funds could be utilized for planned expenses like children’s school fees insurance premiums.

Conclusion

In this post, we have got clear idea about investing in FMPs as it is a tax efficient product compared to other similar investments subject to invest of one-year tenure or more. They are free from interest rate and default risk because the fund managers try to synchronies the maturity profile of debt papers they invest in the duration of FMPs and fetched with the well-diversified portfolio. Though the FMPs are enjoying several tax and low-risk advantages, investors should not treat these as dream products that offer high return with zero risk.

While choosing the right FMP, first decided your investment horizon matching the tenure with a financial goal. If you plan to buy a car after a year, a one-year FMP will be ideal to help make the down payment. But, if you are really not sure whether you can remain invested throughout the tenor of an FMP, avoid investing in the same, no matter how attractive the proposition is. But if you are sure of your cash flows and want higher post-tax returns compared to fixed deposits, a 13-month FMP makes a lot of sense.

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