Monitoring credit risks, a key imperative for FMPs: CRISIL

Executive summary
India's increasing interest rates in recent months have significantly enhanced interest in a hitherto neglected investment category among mutual funds — fixed maturity plans (FMPs). These are investment schemes floated as close-ended mutual funds, and have maturity periods ranging from a month to five years. Taking advantage of the rising interest rate regime, FMPs offer tax-adjusted returns that are higher than those offered by bank fixed deposits (FDs) of comparable maturity. The assets under management in this category have, therefore, grown rapidly in recent months.

FMPs indicate the yields investors can expect at maturity; however, unlike returns from bank FDs and other risk-free investments, FMP yields are not assured. It is, therefore, imperative that investors clearly understand how FMPs achieve higher yields than FDs, and the risks associated with FMP portfolios; this is a corollary of the classical risk-return paradigm.

This commentary accounts for the FMPs' growing popularity as an investment option. It also explains why investors need to closely monitor the credit risks of portfolios that FMPs invest in. Reliable, third-party evaluations of credit risks, such as those by CRISIL's Credit Quality Ratings (CQRs), can help investors evaluate the credit risks in FMPs.

FMPs: why they do what they do
The basic objective of FMPs is to generate steady returns over a fixed-maturity period, thus immunising investors against market fluctuations. FMPs are passively managed fixed-income schemes: the fund manager locks into investments with maturities corresponding to the plan's maturity. This effectively reduces price risks, or the potential to make losses on bonds when interest rates rise, unless there are interim redemptions by investors. Investors are informed of the indicative returns their investments are likely to generate at maturity: the prevalent yield on investments, minus the expense ratio, which varies from 0.25 per cent to 1 per cent of the initial capital mobilised, is the likely return at maturity to the investor. FMPs usually invest in certificates of deposit (CDs), commercial papers (CPs), money market instruments, corporate bonds, and even bank FDs. The plans are predominantly debt-oriented, while some may even have small equity components. In the case of FMPs with equity components, the equity provides an additional boost to returns in the event of a rise in equity markets.

FMPs: an increasingly popular investment option
When interest rates first began to increase, there was an increasing allocation by mutual funds in floating rate funds. The trend has now shifted to an increasing participation in FMPs. As Chart 1 indicates, the number of new schemes launched shows a rising trend: around 400 FMPs were launched during the period between April 2006 and March 2007. March 2007 alone accounted for more than 100 new launches. FMPs are now also being launched in series, back-to-back, with each new scheme replacing one that has just matured.