SANJAY KUMAR SINGH Opt for FMP if you need the discipline of a lock-in

Open-end funds are good alternatives

Currently, the new fund offers (NFOS) of two fixed maturity plans (FMPS) from Aditya Birla Sun Life Mutual Fund are on. The Securities and Exchange Board of India’s (Sebi’s) website shows that fund houses like Nippon India and Kotak have also filed their FMPS, which they will launch soon.

No interest-rate risk

Currently, when there is a possibility that rising inflation and hardening yields in the West could push interest rates higher in India too, an FMP offers investors the benefit that he circumvents interest-rate risk.

“There will be a mark-to-market impact on the portfolio if rates rise. But since the investor holds the fund till maturity, he is not affected,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India.

FMPS allow investors to lock into current yields. The scheme information document indicates the fund’s allocation to instruments of various credit ratings. From this, distributors calculate the indicative yield-tomaturity (YTM) of the FMP. The investor earns a return equivalent to the YTM minus the expense ratio.

Beware of credit risk

A closed-end fund does not offer liquidity, so the investor must stay put for the entire tenure.

“In theory, the investor can exit an FMP by selling on the exchanges, but liquidity tends to be low,” says Arun Kumar, head of research, Fundsindia.

FMPS can also carry credit risk if the portfolio holds poor-quality bonds. “If there is a credit squeeze at the time of maturity, the fund manager will find it difficult to liquidate the poorly rated bonds and return investors’ money,” says Prateek Mehta, cofounder and chief business officer, Scripbox.

In an open-end fund, if a security defaults and the investor believes more could suffer the same fate, he can exit. This option is not available in an FMP.

Sebi has put in place a mechanism for side-pocketing. This has been utilised by open-end funds. The defaulted securities are placed in a segregated portfolio. The fund manager negotiates with the bond issuer to pay up gradually, and then pays back the investor whatever is recovered. In this mechanism, the investor can exit from the main portfolio and only a small part of his money remains stuck.

No side-pocketing has taken place in FMPS so far. When fund houses have not been able to pay up, they have extended the FMP’S tenure. Experts say FMPS may undertake side-pocketing in future if there is a credit event.

Who should invest

Locking up money benefits only one type of investor. “Those who lack discipline, and tend to spend instead of leaving it invested, will benefit from a lock-in,” says Mehta.

If you decide to invest in an FMP, check the portfolio credit quality. “In this environment, stick to funds that invest in the highest-grade securities,” says Mehta. Belapurkar adds that investors should not chase yields blindly, but should be mindful of portfolio quality.

Alternatives available

Most investors should stick to open-end funds where they have the option to exit anytime. Those who have a short investment horizon should go for liquid, ultra-short duration, low duration or money-market funds.

Investors may also opt for open-end funds that follow the roll-down strategy. “If you invest for a period that matches the fund’s average maturity, you will get a return almost equal to YTM minus the expense ratio,” says Kumar.

Many fund houses have launched target maturity funds based on indexes, where you can see the portfolio in advance. They invest in ‘AAA’ public-sector unit bonds, government securities, or state development loans, so there is minimal credit risk. They are a good alternative to FMPS.