Apr 7, 2008

Mutual Funds - FMPs: Don't ignore the risk

FMPs: Don't ignore the risk

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It's that time of the year, when fund houses roll out their FMP (fixed maturity plans) products in response to the attractive yields on corporate bonds. Expectedly, investors view FMPs as a means to clock a higher return at relatively low risk (actually many investors believe there is zero risk in an FMP). While this is mostly true, some points about FMPs are noteworthy.

For the uninitiated, FMPs offer a relatively certain return despite their market-linked nature. They (usually) invest in highly rated securities (like 'AAA' rated corporate bonds) over a defined investment tenure.

From the investor's perspective, FMPs are relatively transparent on two parameters, return and investment tenure, both of which are very critical for the fixed income investor.

FMPs are able to offer a relatively certain return (over a defined tenure) because they have a fairly good idea about the yield on the debt investment at the time of investing. Moreover, they plan to remain invested in the debt investment till maturity.

By doing this, they 'lock the yield'. For this reason mainly, FMPs are a one-time investment opportunity for investors i.e. they are open only at the time of the NFO. And once invested, investors in the FMP can only exit prematurely on paying a heavy exit load (which can be as high as 2 per cent).

A question uppermost in the minds of investors is -- why FMPs launched by several fund houses at the same time have varying yields. To begin with, the yields do not vary by a significant margin. For the same tenure, the yields on debt instruments (with comparable credit ratings) are usually in a range, which is why FMPs of a similar tenure have comparable yields.

However, if you find that yields on a particular FMP are noticeably higher (compared to that of others with a similar tenure), then it's time to look at the portfolio. You can request for the indicative portfolio, which will have a list of proposed debt securities along with the ratings.

If the securities have the highest rating (for instance 'AAA' or equivalent) then you know that the fund manager is not taking on higher risk to give you that extra yield. However, if you see anything less than 'AAA' (or equivalent) then you will have the answer to how the FMP has a higher yield than its peers; it's because the fund manager is taking on credit risk.

Another risk that investors must factor in before investing in an FMP is the yield, which at best is indicative. Based on the situation in the debt markets, it is possible that the fund manager may not get the opportunity to invest in debt instruments with the yield indicated by him at the time of launching the FMP. Investors would do well to treat the yield for what it is i.e. indicative and factor in the odd deviation.

At this stage investors are probably wondering why FMPs give a negative return intermittently. So long as they are invested in debt instruments with a top-notch credit rating, they are meant to give a positive return (or at least that's what they have been told).

To be sure, despite being invested in the best quality debt instruments, fund managers only take care of the credit risk; they are still exposed to interest rate risk. However, they reduce the interest rate risk by staying invested in the debt portfolio over its tenure.

To that end, fund managers are indifferent to the swings in the NAV (net asset value) because they plan to remain invested in the portfolio till maturity. Since the investor is also expected to remain invested in the FMP till maturity, he should ideally be indifferent to the intermittent volatility (if at all) in the FMP's NAV.


Before investing in an FMP:

1) Request for the FMP's indicative portfolio. Look out for debt instruments with less than AAA (or equivalent) rating. In our view, FMPs are ideal for investors who want to generate a competitive return at lower risk. So if the fund manager is taking on credit risk (by investing in lower rated paper), the investment proposition of an FMP loses its appeal and conservative investors must re-consider investing in it.

2) Treat the yield as strictly indicative. While we are not suggesting that the FMP will fail to deliver the return indicated by it at the outset, but given how debt markets work, there is always a chance that the FMP may deviate marginally from its indicative return. As an investor, factor in the variation.

3) Investors must be sure that they intend to stay invested in the FMP until maturity. Only then can they afford to be indifferent to the intermittent volatility in its NAV.

Originally published on Rediff