Safe, predictable and better post-tax returns than bank FDs  

Rising interest rates not only mean rising EMIs but also offer an opportunity to earn higher returns. Debt schemes are now offering attractive returns with short-term rates in the region of 8-10%. Call money rates have been moving higher to about 7.5-8% due to tight liquidity conditions. With the RBI deciding to raise the cash reserve ratio (CRR), liquidity conditions have worsened. Tightness in the money markets is expected to continue till the end of the current financial year and investors can consider investing in short term options like FMPs or floating rate schemes.  

What are FMPs?

Fixed maturity plans, or FMPs as they are popularly called, are close-ended funds with a fixed tenure and invest in a portfolio of debt products whose maturity coincides with the maturity of the product. The primary objective of a FMP is to generate income while protecting the capital by investing in a portfolio of debt and money market securities. The tenure can be of different maturities, ranging from one month to five years.

FMPs can be compared to fixed deposits of a bank. While a fixed deposit offers a 'guaranteed' return, returns in FMPs are only 'indicative'. Typically, the fund house fixes a 'target amount' for a scheme, which it ties up informally with borrowers before the scheme opens. That way it knows the interest rate it will earn on its investments, providing the 'indicative return' to investors.

Benefits of FMPs

FMPs offer many benefits like tax efficiency, fixed tenure and low sensitivity to interest rates. The minimum investment amount is usually Rs 5,000, which a retail investor can easily invest.

Capital protection: FMPs have less risk of capital loss than equity funds due to their investment in debt and money market instruments.

Low interest rate sensitivity: As the securities are held till maturity, FMPs are not affected by interest rate volatility. The actual returns are more or less close to the indicative returns declared at the scheme's launch

Lower cost: FMPs involve minimum expenditure on fund management, as there is no requirement for a time-to-time review by fund managers to buy/sell the instruments constituting the fund. Since these instruments are held till maturity, there is a cost saving in respect of buying and selling of instruments

Tax benefits: FMPs score over fixed deposits because of their tax efficiencies both in the short-term as well in the long-term.

Short-term tax advantage – Dividend option  
Mutual fund dividends are tax-free in the hands of the investor (subject to a dividend distribution tax @14.03% for retail investors and 22.44% for corporate investments), whereas the interest on a bank deposit (except where special 80C approved) is added to the income of the investor and taxed as per his/her slab.

The table below provides an illustration of the tax advantage offered by an FMP – Dividend plan. The illustration is based on a 90-day plan and assumes a 90-day FD yielding 8%, compared with an FMP yielding 8% for an individual investor in the highest tax bracket.

Source: ICICIdirect Research  
Based on 90-day plan, assuming that the entire gain is distributed. The above example is purely illustrative and yield given above is indicative only.

Long-term tax advantage – Growth option  
Long-term capital gains (investment of more than a year) enjoy indexation benefit. So if the investment is for more than a year, in the growth option one has to pay long-term capital gains tax of 20% with indexation, or 10% without indexation on debt products.

Further, with the help of FMPs investors can get 'double indexation' benefit, which is not available in case of fixed deposits and bonds. This advantage can be availed by investing in an FMP just prior to the end of a financial year and withdrawing it after the end of the next financial year. An investor can invest in an FMP before March 31 and withdraw it after April 1 the next year.

Thus, the amount remains invested for a period slightly greater than a year. This ensures the applicability of indexation benefits for inflationary changes in two years, which can help investors, reduce the tax.

Double indexation, in some cases, can even lead to a net loss figure, even though there is a profit, and thus expunges the tax obligation of the investors.

The taxable amount is calculated using the following formula:

Taxable Gains = Amount Returned – (Amount Invested x Inflation Index for Redemption Year/ Inflation Index for Investment Year)

The following example explains this concept:

We take an example of a 400-day FMP, which, if launched on March 1, 2007, will mature on April 4, 2008. It will pass through two financial years and thus has the benefit of double-cost indexation for the purpose of calculating post-tax yield.

Note: Cost inflation index (CII) for FY06-07 is 519. The assumption is that the CII for FY07-08 is 545 and for FY08-09 is 572, at an inflation of 5% annually. Tax rate includes a surcharge of 10% and cess of 2%. The workings are indicative only and are based on current taxation laws.  

Source: ICICIdirect Research
Based on 400-day plan, assuming that the entire gain is distributed. The above example is purely illustrative and yield given above is indicative only.

Conclusion
If the investment horizon is less than a year, the dividend option appears more tax-efficient, where as for investments of over a year one may opt for the growth plan, which provides the benefits of indexation.

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