Apr 7, 2008

Mutual Funds - How could a FMP gives a negative returns?

Why FMPs turn negative?

Fixed maturity plans (FMPs) were an innovation designed mainly to give investors a fairly certain rate of return in the backdrop of interest rate instability. FMPs are close-ended debt funds (investments can be made only during the new fund offer period) with a fixed maturity horizon (i.e. the investment maturity, which is fixed, is declared at the outset). They invest across debt instruments to arrive at a pre-determined yield. The pre-determined yield is the indicative yield that FMPs usually declare before hand at the time of new fund offer period (NFO). This way, investors are aware as to how much return their investment will deliver on maturity.

FMPs target the given yield by staying investing in the portfolio of debt instruments till maturity. Given the structure of FMPs, investors have an impression that their returns are always in positive terrain and that they can never turn negative. However, investors would do well to understand that by virtue of being market-linked, there is a possibility of debt investments going negative intermittently. So there could be phases when investors could find the net asset value (NAV) of their FMP investments dipping over a day or a week.

At Personalfn, we have seen investors get worried every time their FMPs slide into negative terrain. The fact is, because it's an FMP, you don't need to worry (assuming that there the quality of the portfolio is top notch). Since the fund manager has a fixed investment tenure, the intermittent dip in the portfolio value is temporary and will get ironed out over time.


Why do debt funds turn negative?

A matter of intrigue for investors is how a debt fund can give a negative return. Usually, these are the investors who have been told that debt instruments can only move in one direction – upwards. To be sure, this is a fallacy. While relative to their equity counterparts, debt instruments do not venture into negative territory as often, they do when the situation warrants it. Debt instruments and by extension debt funds and FMPs are prone to a downturn particularly when there is pessimistic news on the economic front (i.e. inflation, interest rates among other factors).


An illustration

Still confused how a debt instrument can turn negative? A brief illustration should unravel this. For instance, let's assume that a bond (we will call it Bond A) has a coupon rate of 8%. Suppose there is an increase in interest rates and the new bonds (Bond B) are issued with a coupon rate of 9%. With the introduction of Bond B at a higher coupon rate, the yield on A will adjust higher. This will result in a fall in the price of Bond A (since bond yields and prices are inversely related). Consequently debt funds that hold Bond A will be impacted. When there are many bonds like this in a debt portfolio, the cumulative impact on the NAV is negative.


Why FMPs are not at a risk

FMPs are structured in a manner so as to achieve the indicative return or yield on maturity. The operative word over here is 'on maturity' not in the intermittent period. Since they lock-in the yield at the time of investment and stay invested till maturity, the intermittent market fluctuations do not impact their maturity proceeds.


What should FMP investors do?

First and foremost do not get ruffled every time your FMP witnesses a dip in its value. However, there is something that you can do i.e. check whether the FMP is invested in instruments with the highest credit rating (like AAA or sovereign for instance). Since indicative portfolios are released by the fund house before the launch of the FMP, you have this opportunity before investing in the FMP. That way you can ensure that you earn a high yield at lower risk. Of course, if you find all this confusing and feel the need for professional assistance, your financial planner is best suited to help you identify the right FMP. Source- Rediff