FMPs - Alternative To Bank Fixed Deposits With Tax Efficiency

This time of the year, you see lot of FMPs hitting the market.  Wondering what is FMP!

FMP stands for Fixed Maturity Plans offered by Mutual Funds in India.  Mutual Fund houses collect money through an FMP scheme and lend that money to borrowers for a fixed maturity periods or buy commercial papers or bonds which matches with the scheme maturity date.  The FMPs are debt instruments and they dont have any equity exposure at all. Also, the FMPs would invest in rated securities which gives additional comfort as far as the quality of credit instruments held by the FMP scheme.

It is being positioned as an alternative to bank fixed deposits by the fund houses.   Yes, FMPs are an interesting alternative with highly tax efficient structure due to indexation benefits on Capital Gains.  We will see how this beneficial from a tax perspective.

The process works like this.

What happens in a bank fixed deposit?
You invest Rs10000 and receive back Rs11000. The difference between the original investment and the maturity value is treated as interest income and taxed as "interest from other sources" in case of bank deposits.

What happens in a FMP?
Taking the same example above, the amount invested is considered as the cost of purchase of a financial asset, in this case, mutual fund units and the maturity amount is taken as the sale consideration.  So, the difference between the purchase price and the sale consideration is treated as profit on this asset.

Whats the big deal about this?
When it is treated as interest, it gets added to one's taxable income and get taxed at the applicable income tax rates of the individual (in case of bank fixed deposits)

When it is treated as profit, then the Capital Gain provisions kick in for tax calculations.  As you may be aware, Capital Gains have preferential tax treatment and the highest tax rate is 20% which is lower than the 30% tax rate for general income tax calculations.  Also, you get indexation benefit from financial assets held more than 1 year.  The beauty is if it is held across two different financial years, you get double indexation benefit.  For example, you purchase a 390 days FMPs on 10th March 2013 and it will mature on 05th April 2014.  So, in this case, you will get indexation benefit for 2 years, that is, for FY 2013-14 and 2014-15.  This is called double indexation.

Can it replace the Bank Fixed Deposits completely? 

Okay, then the moot question is can it completely replace the Bank Fixed Deposits in one's portfolio.  The simple answer is NO.

The following are the reasons why you need to maintain a balance between bank fixed deposits and FMPs:

Liquidity:   The liquidity provided by bank fixed deposits are unmatched currently by FMPs . FMPs are close ended instruments which are listed on the stock exchanges but the volumes are not very encouraging.  For that matter, trading in debt instruments in India is still at a very nascent stage putting at little risk the liquidity of FMPs.

No up front disclosure of Interest rates:  Secondly, there is no guaranteed interest rates by the Mutual Fund houses in respect of FMPs.  Bank Fixed Deposits disclose the interest rates up front but in FMPs it can not be disclosed by Fund Houses due to SEBI restrictions on the same.

Opaqueness in FMP scheme holdings:  It is not disclosed by the Fund House prior to your investment where and which instruments they would be subscribing to.  As such, you have to go with the stated objectives in the Key Information Memorandum of the scheme.  But having said that, I would not give too much weightage to this argument because even banks don't disclose where they invest or lend at the time of taking deposits from the investor.

Suitability of FMP:

Who should invest in FMPs?

1.  People who are in the highest tax bracket as it provides tax efficiency

2.  Investors who have adequate bank deposits to meet emergency situations and looking to diversify beyond bank deposits


So are you looking for tax efficient alternative to Bank Fixed Deposits?  Look no further than FMPs.

Please feel free to write back to us (venkytuty@gmail.com) if you require any further information on FMPs or help in making investment in FMPs.

PFC Tax Free Bonds - Dec 2012 - Review

Power Finance Corporation – Tax Free Bonds – Dec’12                                                  Subscribe

Power Finance Corporation is a “Navaratna” company of Government of India.  It is engaged in the business of lending and advisory services from project conceptualization to post commissioning for clients in the power sector.

Issue Details:

PFC is issuing “Tax Free Bonds” , which are secured, redeemable and non-convertible debentures to an extent of Rs1000 crores, with an option to retain up to Rs4,590 crores of oversubscription. 

Face Value	Rs1000 per Bond	Minimum Application	Rs 5000 or 5 Bonds
Interest Rate	7.69% for 10 years option 7.86% for 15 years option	Mode of Allotment	Dematerialised and Physical Form
Credit Rating	Crisil  - AAA; ICRA – AAA	Listing	Bombay Stock Exchange
Issue Open	14th Dec 2012	Issue Closes	21st Dec2012

Financial Details of PFC:

·         Existing profit making PSU – FY 2011-12 profits of Rs3031.74 crores

·         EPS – Rs23.41 for FY 2011-12

·         Loan Assets at Rs140,819.21 crores as of 30-Sep-2012

·         Consistent growth in loan assets and profits over the last 5 Financial Years

Tax Benefits:

·         Tax Free Bonds – Interest income fully exempt

·         No Wealth Tax applicable

·         Since it is a listed bond, benefits of indexation available in case of sale in stock exchanges

Investment Recommendation:

 The PFC tax free bonds are an attractive investment opportunity for resident individuals who are in the highest tax slab.  With the interest rate expected to move southward from 2013, the tax free rate of 7.69% for 10 years and 7.86% for 15 years is on the higher side. 

This issue has a highest credit rating from Crisil and ICRA indicating sound credit quality and prudent asset recognition norms, which lends a high degree of security to the investors. The listing of the shares on the stock exchanges provides an excellent window for exiting the investment if need arises in the future. 

On the downside, committing funds for a minimum period of 10 years is required.  There is a possibility of interest rates moving against the investor is there, though the chances of it are very low over the next 10 years.   The asset book is skewed towards power sector, which is going through a difficult phase all over India.  The State Electricity Boards which are one of the primary borrowers of PFC is in doldrums across many states in India.  Considering that there is a major reform process initiated in the power sector recently by the Central Government and most of the state electricity loans are guaranteed by the respective state governments, the possibility of default is limited.  But the risk is definitely there.

Verdict:

Considering the overall risk profile of PFC and its good performance over the last several years, we think it is an attractive opportunity to lock-in some money at the current rates.   This is a good quality debt instrument with add on benefits like tax free status, easy liquidity through stock exchange listing. 

Couple of caveats is that you should have exhausted your Provident Fund and Public Provident Fund contribution limits before you look at this.  Secondly, you should remain in the tax slab of 30% during the entire tenure of the investment.  That is, it may not be suitable for people who are going to retire in the next few years.

We recommend the investors to go for the ten year option.  Yes, NRIs can also invest.

If you need any assistance in investing in this Bond issue, please feel free to write to me at venkytuty@gmail.com or call me on +91 98415-67379. 

Disclaimer:

This is not an invitation to subscribe to the Tax free bond issue of PFC.  You should consult your personal financial advisor or take your own decision on this investment.  Please read the offer document completely before making any investment decision.

Disclosure:

The author or his firm, Acuwealth Advisors, may or may not be investing in this bond issue.  Also, if you decide to invest through us, we may be getting some commission from the product manufacturer.