Last week we looked at closed-ended mutual funds, and how they differ from open-ended mutual funds. We also took up in detail the other pros and cons of closed-ended equity funds. This week, we take up closed-ended debt funds; more specifically, FMPs. There are several other types of closed-ended debt funds which we will look at in detail in the coming weeks.
What are the types of Closed-ended Fixed Income Mutual Funds?
As with all closed-ended funds, debt-oriented closed-end funds are open for subscription only during the NFO period. The basic features as we discussed last week about closed-ended funds in general apply to debt-oriented closed end funds.
Debt-oriented closed end funds are either purely debt or mostly into debt with some exposure to equities. The pure-debt funds are Fixed Maturity Plans (FMPs) and Fixed Term Plans (FTPs). Hybrid funds consist of interval funds, Capital Protection Oriented Funds (CPOF) and Dual Advantage funds. We will be looking into how the CPOF, interval, and dual advantage funds work in the subsequent weeks.
Where do they invest?
FMPs or FTPs are debt funds that have a fixed maturity horizon. This horizon can vary from three months to up to three years or even five years. An FMP invests across debt instruments – money market instruments, certificate of deposits, commercial paper, corporate debt and government bonds, depending on its maturity and strategy. It holds these instruments and collects the interest due on them, or what is called accrual.
An FMP chooses instruments with residual maturities that match its own. For example, a three-year FMP will have an average portfolio maturity of three years. This ensures that the fund receives the interest due to it at the time it matures. It removes the risk that instruments it holds will not deliver as needed, and that the yield is in tune with the timeframe.
What are their pros?
The NAV fluctuation that you may see with open-ended debt funds is not too prevalent with FMPs. FMPs lock into yields, hold instruments to maturity, and ensure that the interest accrued is received. You are also locked into that FMP. Open-ended debt funds can see their NAVs fall as market prices of instruments react to interest rate movements, liquidity factors, or credit rating movements. FMPs also have lower portfolio churns.
Locking in at peak rates
If an FMP is floated at the peak of a rising rate cycle, it can deliver better than open-ended debt funds. As the FMP would lock in at high rates and hold these instruments, it will earn the best yield at the time. An open-ended fund would first see a positive impact as bond prices would rise in reaction to falling rates. But subsequently, new debt papers added to the fund will be at lower rates, therefore bringing down portfolio yields.
FMPs of over 3-year maturity have indexation benefits on long-term capital gains, lowering tax outgo and thus improving post-tax return. This indexation is not available for fixed deposits. And as FMPS anyway invest in instruments that pay out better interest rates than fixed deposits, the tax benefit adds to their advantages.
What are their cons?
No exit route
This is the general risk for all closed-end funds. Your investment is locked in for the tenure of the scheme with limited opportunity to exit midway; though they are listed on the exchange, low liquidity means that exiting is not easy. An FD may be broken during the tenure for a penalty. It is on account of liquidity that FMPs lose out to FDs, despite providing comparatively better post tax returns.
As explained above, locking in at the peak of a rising rate cycle will ensure better returns. This brings up the risk of timing. If you invest in an FMP at the bottom of a rate cycle, you will lose out. As rates begin to rise, an open-ended debt fund can quickly move on to higher coupon debt papers. An FMP, on the other hand, would have locked in at lower yields and will not have the freedom to change the portfolio as it matches the instrument maturity with its own maturity.
FMps are not as safe as fixed deposits. They do not come with any insurance on the investment made. Any default or delay in payments by the underlying paper can reduce the return significantly. Thus, do your homework before investing in one. The Scheme Information Document will have some details on where the fund plans to invest. It will also give you a rough idea of the kind of yields you may earn.
Once the FMP matures, it may not be possible to get similar returns from investment avenues open at the time. This is a risk with fixed deposits as well. If the interest rate cycle falls at the time of the FMP maturity, there is the risk that returns are low. Another risk is that you don’t reinvest it at all and wind up spending it.
FMPs are a good option if you do not need the money for a certain period and actually have a goal for that amount at the end of the tenure. They can act as a substitute for your FDs, if you can take a little bit more risk for better returns Always make sure to choose an FMP with a tenure that matches your requirement.