What are pros and cons of fixed income products?

In an interview with CNBC-TV18's Mitali Mukherjee, Rajiv Deep Bajaj, VC and MD, Bajaj Capital, Naval Bir Kumar, president and CEO, IDFC Asset Management, Amitabh Mohanty, head-fixed income, Reliance MF, speak pros and cons of fixed incomes or fixed maturity plans (FMPs).

Also read: Are ULIPs investor friendly? More importantly, can they save you tax?

Below is a verbatim transcript. Also watch the accompanying videos.

Q: Why a fixed income product or why an FMP?

Kumar: Fixed income product, from an asset allocation perspective, you need to have some money in fixed income, even if you are exceedingly young. You never know when you may need to withdraw cash, maybe for an emergency, maybe for any other aspect of your life. It may not always be a favourable time to remove money from risk assets. So, you must have some allocation to fixed income. Obviously, the older you are, the allocation should be higher.

In terms of FMPs, FMPs are basically the mutual fund industry's way of trying to mimic a fixed deposit. If you look back, the entire fund industry was created because of the disintermediation cost. For a bank whenever they raised money, they need to maintain statutory reserves, they need to maintain capital adequacy. Hence, the gap between the rates at which AAA bonds trade and the rate at which banks are able to raise deposits is a fairly healthy gap. And that is what caused the mutual fund industry to be created in the US where people were keen to pool assets together and buy into AAA bonds directly and were happy to take credit risk for high yield.

Through the FMP we are trying to do the same thing. We buy bonds with absolutely the same maturity as the tenure of the FMP and we buy highest rated bonds. FMPs tend to give much better quality returns than fixed deposits and they also have better tax efficiency.

Q: The question that needs clearing for an investor going into this product is what kind of reasonable returns can I expect to get when I invest in a product like this. What would your answer be to that question?

Bajaj: From an investor's point of view, it is a risk-reward equation. Today, an investor when he evaluates debt versus equity, he is saying that maybe over a couple of years horizon I am looking at 15% returns on equities vis-à-vis I am getting 10% kind of returns in a fixed income product. So, therefore, last couple of years we have noticed there is a genuine trend among investors to go for fixed income options.

Now, what happens is that if you invest in a bank fixed deposit or a company fixed deposit, while you get a locked in return, but you are also paying the marginal rate of tax. So, hence, for an investor in high tax bracket, it is good to look at options like FMPs where you get tax efficient returns.

With the kind of short-term and medium-term interest rates that are prevailing in our economy right now, you are getting new FMPs where the carrying yields of the underlying portfolio is as high 9.5-9.75% return. So, what you are looking on as an investor is a net return of 8.5-9.0%, which is way superior to what you will get when you put your money in a fixed deposit.

Q: What's the difference between an FMP and an income fund and a debt fund and of course you have got corporate deposits as well? How would these little brackets fit into the entire world of fixed income investing?

Mohanty: See FMPs are essentially close-ended schemes where as per the current Sebi guidelines there is no exit by redemption. Obviously, these products are listed in the stock exchange and give limited liquidity. But broadly speaking these products are reasonably good from a return perspective, in the sense that point to point volatility returns is pretty low, but do not score very high, if you need intermediate liquidity.

On the other hand, income funds, debt funds etc, are open ended funds. Returns can vary, can become reasonably volatile given the market conditions and especially if investors are looking for shorter term horizon. So, ideally speaking if you are looking for an income fund or a debt fund and you have a horizon of say one-and-a-half to two years, I think they are great products because they give portfolio managers the wherewithal to actively manage these portfolios and generate the alpha over standalone static returns from fixed deposits or FMPs. But investors need to be very clear about the time horizon of investment and their appetite for volatility.

Corporate deposits, on the other hand, you do see quite a few corporates issuing for retail investors. But what the investors need to realise very well is that if you are directly invested in corporate deposits, the scope for diversification is very low. You normally end up investing in a few corporates. Therefore your concentration risk or credit risk of individual corporates that you invest in is quite high. Furthermore investors investing in corporate deposits directly should be very aware of their ability to evaluate credit risks.