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Tax-efficient fixed maturity plans a good investment option now
August, 19th 2013

In the past few weeks, the fixed income landscape in the country has changed drastically. Following the unprecedented liquidity tightening measures by the RBI in response to the sliding rupee, short-term rates have jumped up sharply. This has increased the attraction for investments in short-term debt instruments, such as the one-year certificates of deposit and commercial paper.

The rates have risen to 9.5-10% for certain instruments, up to 150 basis points higher than that a month ago, when sliding interest rates had increased the preference for longer tenure instruments.

The fund houses have been quick to take advantage of the short-term rates, with nearly all AMCs launching fixed maturity plans (FMPs) of different tenures in the past month. Should you bite the bait and include FMPs in your portfolio? If so, how should you identify the right one?

Why invest in FMPs now

These plans invest in a mix of short-term options, such as money market instruments, certificates of deposit, commercial papers, and the like. Given that these are currently offering a yield of 9.5-10%, the funds are also likely to deliver a similar pre-tax return. The investors who lock in money at the current level should enjoy double-digit returns over a one-year horizon.

The uncertainty regarding the future interest rate movements makes FMPs a safer bet. The reversal in rates had played out to the hilt, giving a fillip to bond prices, especially those of longer duration. However, the recent RBI move to tighten liquidity has put a big question mark on the trajectory of rates. Debt funds, across categories, have taken a knock and there is a heightened element of risk.

FMPs, on the other hand, offer returns that are relatively predictable, though not guaranteed. These are closed-ended, or of a fixed tenure, where the fund invests in instruments with a maturity profile matching that of the fund, and the instruments are typically held till maturity. For instance, a one-year FMP will invest in fixed income instruments bearing the same maturity. As such, any gyration in interest rates in the interim period does not affect the value of the fund.

Hence, in an environment where the stability of the debt market is suspect, an FMP provides a safer way to navigate the uncertainty. Says Hemant Rustagi, CEO, Wiseinvest Advisors: "This is a good window for investors to lock in their money at higher yields through FMPs." They should supplement the riskier open-ended funds in their portfolios with more stable FMPs, he adds.

Besides, FMPs are more tax-efficient. The plans with a horizon of more than a year provide the benefit of indexation, where investors are allowed to adjust returns against inflation. If you invest in the growth option of a one-year FMP, your returns are taxed as capital gains at a rate of 20% with indexation, or 10% without indexation. In case of fixed deposits, the interest is clubbed with income and is taxed as per the specified slab rates. So, if you fall in a higher income tax bracket of 20% or above, an FMP would be a better choice than an FD. During periods of high inflation, the indexation benefit allows you to enjoy near-zero tax on capital gains. However, the gains from FMPs with durations of less than one year will be taxed at your applicable tax rate, bringing them at par with FDs.

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