Fixed Maturity Plans

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Fixed Maturity Plans

Why in news?

• Investors in debt mutual funds have been hit after Kotak Mutual Fund and HDFC Mutual Fund wrote to their investors acknowledging that they have exposure to securities of troubled Essel Group companies.

What are FMPs and what is the issue that fund houses are facing?

• FMPs are fixed tenure mutual fund schemes that invest in debt instruments including government securities, commercial papers, non-convertible debentures and certificate of deposits among others, and thus generate interest income for their investors.

• FMPs are closed-end debt funds with a maturity period that can range from one month to five years. Because debt funds enjoy long-term capital gains tax after three years, typically three-year FMPs are now popular.

• FMPs are predominantly debt-oriented, and their objective is to provide steady returns over a fixed-maturity period, thereby protecting investors from market fluctuations.

Why are FMPs in focus now?

• A few FMPs holding paper of Zee/Essel Group have come up for maturity starting April 8.

• On maturity, these schemes should pay back full amount to investors which includes principal plus earnings on the portfolio.

• However, since these FMPs have paper belonging to Zee/ Essel Group in their portfolios, one fund house is repaying investors money minus their holding in Zee/Essel paper.

• Another fund house has proposed to rollover its FMP by a period of 380 days.

How do FMPs work?

• An FMP portfolio consists of various fixed-income instruments with matching maturities.

• Based on the tenure of the FMP, a fund manager invests in instruments in such a way that all of them mature around the same time.

• During the tenure of the plan, all the units of the plan are held until they mature on a specified date. Thus, investors get an indicative rate of return of the plan.

Where do FMPs invest?

• FMPs usually invest in certificates of deposits (CDs), commercial papers (CPs), moneymarket instruments, non-convertible debentures over a defined investment tenure. Sometimes, they also invest in bank fixed deposits.

Are FMPs liquid?

• Since FMPs are closed-end funds, they can only be traded on the stock exchange where they are listed. However, trading in these units is negligible which makes FMPs illiquid. Compared to this, openended debt funds can be bought or sold on a daily basis.

Benefits of FMPs for investors

• Capital protection and no interest rate volatility: Since FMPs invest in debt instruments, they provide low risk of capital loss as compared to equity funds. Since the securities in the portfolio are held till maturity, FMPs are not affected by interest rate volatility.

Taxation benefit: FMPs offer better post-tax returns than FDs as well as liquid and ultra short-term debt funds because they offer indexation benefits.Indexation helps to lower capital gains and thus lower the tax. Triple indexation allows an investor to take advantage of indexing his investment to inflation for 4 years while remaining invested for a period of slightly more than three years.

Lower expense ratio: Since these instruments are held till maturity, there is a cost saving with respect to buying and selling of instruments, thereby resulting in a lower expense ratio for investors.

Should debt mutual funds worry?

• While debt mutual funds are considered relatively safe investment instruments, the news of Kotak Mutual Fund writing a letter to investors and acknowledging that it has invested almost 27 per cent of the investment corpus of its Fixed Maturity Plan Series 183 in three troubled entities facing severe liquidity crises — IL&FS Transportation Networks Limited, Edisons Utility Works, and Konti Infrapower & Multiventures — has sent shockwaves through investors.

• Facing similar pressure on account of exposure to Essel Group companies, HDFC MF has decided to extend the date of maturity of one of its FMPs from April 15, 2019 to April 29, 2020.

• In the case in question, investors who had invested their money in Kotak MF’s FMP in November-December 2015 were ideally supposed to get their capital along with interest income on the date of maturity, April 10, 2019.

o However, since the fund house had high exposure (almost 27% of initial corpus) to ITNL and two Essel Group companies that are facing a liquidity crisis, the fund house is not in a position to fully honour its commitment.

o The fund house said that it had repaid 99.25 per cent of the investors’ initial investment, and that it was working towards optimal recovery from two Essel Group companies by September 30, 2019.

o Other mutual funds with exposure to Essel Group companies and the IL&FS Group are also set to face similar pressure when their FMP or debt scheme needs to repay investors on maturity.

A bigger worry?

• While banks are already facing a crisis of NPAs on account of default by a number of corporate entities including large companies, the news of mutual funds having exposure to such companies has alarmed investors in mutual funds.

• If a corporate entity defaults on their payment to the investee schemes, it in turn takes away the ability of the fund house to honour repayment to investors, thereby putting both the interest income and capital investment at risk.

• It is learnt that mutual funds have exposure of around Rs 3,000 crore to IL&FS Group entities, and of around Rs 7,000 crore to the Essel Group. There may be other such investments that may call for some scrutiny.

Retail investors

• While debt-oriented mutual funds are mostly subscribed to by corporate investors and high net-worth individuals (HNIs), or those investing Rs 5 lakh and above, the share of retail investors in such schemes has grown over the last four years.

• As of December 2018, while the total asset under management of debt-oriented schemes stood at Rs 694,506 crore, the share of retail investor money amounted to Rs 72,214 crore or 10.3% of the total AUM.

• In December 2014, the share of retail investor money in debt-oriented schemes was 6.8%. On the other hand, the share of corporate investment in debt-oriented schemes currently stands at 51.5% , and HNIs’ share is around 36%.

• So, retail investors too have exposure to such schemes and their money is at risk on account of fund houses’ exposure to Essel Group companies.

• Looking at equity-oriented schemes, retail investors are the dominant players and their share in the total equity-oriented schemes’ AUM of Rs 8.4 lakh crore is nearly 52%.

Past instances

• While the exposure of MFs to Essel Group companies has come as a fresh concern, a series of defaults by the IL&FS Group companies on CPs beginning August 2018 had put them under a lot of pressure then.

• Many corporates, mutual funds, and insurance companies invested in CPs and NCDs of the IL&FS Group, and following the default their funds have been locked in IL&FS debt instruments, leading to a liquidity crunch.

• The situation created a liquidity shortage of over Rs 90,000 crore in the system.

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