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October 30, 2018

FMPs: The debt fund option in a rising rate scenario

Investors with a low risk appetite have a plethora of options to choose from among debt mutual funds. One such option is fixed maturity plans (FMPs), which are loosely comparable with bank fixed deposits. The main feature of FMPs is that they lock in the prevailing yields for the entire investment period, which makes them attractive in a high or rising interest rate environment. Read on to understand more about FMPs and how one can make best use of them.


Locking into higher rates through a buy-and-hold strategy


FMPs are close-ended debt funds that investors can only invest in at the time of a new fund offer (NFO) and exit after they mature. FMPs come with a pre-defined maturity tenure, which can range from three months to five years, and they invest in fixed income securities such as money market instruments, government bonds and corporate bonds across the credit spectrum.


As FMPs follows a buy-and-hold strategy, it helps investors to lock in the prevailing yields in the market. Hence, investors in FMPs benefit more in a high or rising interest rate environment as they can capture higher yields compared with a low interest rate trend. Since yield levels are hardening currently (chart 1), FMPs can be a good investment option for investors who are uncertain about the future interest rate trend and want to lock in the current yields.


How FMPs compare with bank FDs


Investors typically favour bank FDs because they know in advance the interest that they will earn on their deposits, which is not the case with debt funds. However, FMPs are an exception among debt funds as an investor can gauge the returns by studying the details pertaining to the proposed portfolio structure and rating distribution of a FMP in the scheme information document, which is disclosed by fund houses at the time of the NFO. For instance, for a three-year FMP that invests in AAA rated bonds, an investor can get a sense of what the returns will be by studying the prevailing yield levels of bonds with three-year maturities. This structure makes FMPs comparable to banks FDs.


The biggest comfort that investors draw from FDs is guaranteed returns, while debt mutual funds are exposed to two types of risk primarily, interest rate and credit risk. As bond prices are inversely related to yields, the net asset values (NAV) of open-ended debt funds are sensitive to interest rate changes in the market, making them volatile. However, investors in FMPs needn’t worry about interest rate risk as the fund captures the current yields by holding the underlying securities until they mature. Hence, an investor will get returns equivalent to the yields prevailing at that time despite the volatility in interest rates during the holding period.