FMPs – Not as risk free as they are made out to be

Unlike a fixed deposit where the returns are guaranteed, in the case of an FMP the return in only indicative. A mutual fund cannot guarantee returns.

To understand what the word indicative means in this context lets first try and understand how an FMP works. An FMP like a fixed deposit has a certain maturity, which usually ranges anywhere from fifteen days to fifteen months. In some cases the maturity can go up to as high as three years. Which basically means that an FMP maturing in one year looks to essentially invest in securities, which would also mature in a year's time. Depending on the return that the securities maturing in one year are yielding, the FMP indicates a yield to the mutual fund distributors who in turn convey the same to investors.

Now, the money that is collected by the particular FMP is invested in these securities and the fund manager in most cases need not worry about the investment till maturity. In other words, FMPs involve a passive style of management. Conversely, in the case of equity or a normal debt fund, a fund manager needs to actively manage the investments to maintain the return. Now, the risk in an FMP comes into play as there is a chance that the FMP may not meet the indicated yield, because it is not able to find enough securities that match that yield to invest in. This is one reason why the returns are indicative and not guaranteed.  

Also, the simplest way to make an FMP more attractive is to offer higher indicated yield. For example, say FMPs of a one-year maturity generally are indicating a yield of around 9%. Now if a mutual fund wants to make its FMP a little more attractive than others, it may choose to offer an indicated yield of 9.5%. To meet this indicated yield the mutual fund will have to generate that much higher return.

How does the mutual fund ensure that it generates this higher return? By investing in debt securities of a slightly lower grade i.e. securities that are a little more risky. Debt securities of different companies have various levels of risk attached to them. The securities that are perceived to be more risky (as per the credit rating) promise a greater rate of return for incentivising investors to buy. So to earn a greater return FMPs will have to invest in such risky securities. And with an increased risk, the chances of a default on the payment of interest or principal are also correspondingly higher. And needless to add, if the default really takes place, there is no way that the FMP can meet the indicated yield. Net-net investors should be vary of an FMP offering a substantially higher indicated yield than what others in the market are generally offering.

Maturity mismatch
As mentioned above, a one-year FMP needs to invest in debt securities that mature in one year. When an FMP is launched, the fund manager does not know in advance exactly how much money it will collect. Upon the scheme closing, chances are the fund manager may end up with an amount greater than that was initially invested. This might lead to a situation wherein there might not be enough one-year securities available in the market. Ideally the fund manager should wait till he finds the security, which matures in line with the FMP. However, this is not what happens in reality.