The irrelevance of Kotak Mahindra mutual fund’s FMP ban

While it does send out a strong message, there is something to ponder over. Let's say the ban comes into effect from September-2021. The six-month period will thus end around late February-2022.

Now here is the interesting thing. FMPs are generally launched/pushed near the end of the financial year, i.e. in March. Some FMPS are also launched earlier or later depending on an AMC’s view of future interest rate scenario and their intent to lock-in on some of those views.

Thus there is a lot of seasonality to FMP launches. But why?

Because launching an FMP around the month of March allows investors to get an additional year of indexation, thereby lowering their tax liabilities further. This is often termed as the double indexation benefit.

Let us use a simple example to explain how this works and why a lot of FMPs get launched in March every year.

As is known, long-term capital gains (LTCG) in debt funds are taxed at 20 percent with indexation if the holding period is over three years.

Suppose you invest in it towards the end of the financial year, somewhere around early-March 2021 and plan to remain invested for ‘about three years’, you will redeem it in late March 2024 after completing the holding period and will become eligible for LTCG tax. But if you wait just a bit more, and redeem in early-April 2024, you get to use 4 indexation adjustments (namely for FY2021-22, 2022-23, 2023-23, and 2024-25).

So by holding slightly above three years (or 36 months) and going for let’s say 37-38 months, you get the benefit of one extra year’s indexation.

Here is an illustration of the concept (if you are comfortable with calculations) here:

So by starting in March and waiting for a little more than three years, investors can avail four years’ indexation benefit.

And this is the reason why three-year FMPs are primarily launched in March every year and are of a slightly longer time frame than the exact three years (or 1,095 days). You will see a lot of FMPs with tenures like 1,100 days, 1,151 days, and 1,234 days, etc.

So banning the AMC for 6 months that gets over just before the FMP season begins is something to think about.

Occasionally, AMCs do launch FMPs at other times of the year as well when interest rate expectations change. So no doubt, this 6-month ban on FMP issuance will have some impact on AMC’s business in the near term.

SEBI wanted to -- and did -- send out a strong message to all AMCs that it will not let such events go unnoticed or unpunished. So kudos to the Indian regulator here!

Should you invest in FMPs?

That is debatable. But let’s discuss.

FMPs are closed-ended debt funds that aim to provide predictable returns over a fixed maturity period. The fund manager curates a portfolio of different fixed-income instruments with maturities matching that of the FMP maturity timelines.

Since the investments are made in corporate debt, the FMPs are expected to deliver higher returns than bank fixed deposits (FDs). More so if you consider the three-year indexation benefit that kicks in as most FMPs are of 3+ years duration (as explained earlier as well).

But that doesn’t mean that FMPs are risk-free and the SEBI penalty in itself shows that. FMPs are exposed to a lot more credit risk than FDs though interest risk is negligible. All FMPs are not created equal. Some take higher risks by investing in below-AAA-grade instruments for extra returns. So the risk of default or delay in payments in FMP does exist, no matter what you have been told by the "FMP-is-as-safe-as-FD" crowd!

When you invest in FMP, the portfolio is also not known. You have to go through the Scheme Information Document (SID) to get some idea about the indicative portfolio quality. But the actual portfolio composition is disclosed only after allotment. So FMPs are not transparent at the time of investment.

Though you can make intelligent guesses by looking at the portfolios of other debt funds and FMPs managed by the fund manager.

FMPs are good, but...

High net worth individuals (HNIs) prefer FMPs it is viewed as a tax-efficient alternative to bank FDs. But the assumption is that they do understand what they are getting into from a risk perspective or are properly advised/informed by their advisors/distributors.

For large investors, a carefully selected FMP portfolio can still be a part of the overall debt portfolio. But for small investors, there are a lot of variables and unknowns in FMPs.

So, it is best to avoid these closed-ended FMPs altogether and to stick to a few schemes in some of the safe debt fund categories.