#MutualFundKickstarter: Get the Close-End Debt Fund Advantage
Published On: 21-Jun-2018

What comes to your mind when you think of making investments for future needs?

Surely, your mind immediately races towards major needs in the distant future, be it investments for child’s college or your retirement. At the same time, there would be many needs that need to be met much earlier, typically in 3-4 years of time. This would typically be requirements like money for home down payment, vacation, besides child’s school admission expenses.

As an investor, your choice of investments will be very different for these needs when compared to investments for the ones in the distant future. Let’s take a closer look.

Separate investments

For distant needs like child’s higher education, consider higher risk investments that also have a potential for high growth in the long term. This typically takes you to equity funds, which invest in equities. Due to these investments, equity funds experience short term turbulence. However, these bumps typically smoothen out over a longer period of, say, 8-10 years, or more.

 

Clearly, for requirements expected to arise in the next 3-4 years, you need different investments whose returns will be far more stable. This attribute required from an investment for shorter term needs, typically takes people to fixed deposits (FDs). But that is far from appropriate for these requirements. Take a look at two major issues an investor typically faces with FDs.

Tax hit

Fixed deposits provide you with interest income. This gets added to your income in full and you pay tax at the applicable tax rate. This hurts those who are in the highest tax bracket. Of course, if the same growth in money accrues to you in the form of capital gains in debt investments where you stayed invested for 3 years or more, you gain from twin tax benefits.

First, you are taxed at lower rate since the applicable long term capital gains tax in this case is 20%. Next, you also benefit from inflation indexation benefits on capital gains for which you are taxed. For tax purposes, inflation indexation enhances cost at which you acquired the investment and thus reduces the amount of tax you pay. Here’s how it works.

Let’s assume that you invest Rs 10,000 and redeem the investment after 3 years with a capital gain of Rs 3,000. If the inflation adjusted value of your investment is Rs 2,000, you need to pay only Rs 200 as long term capital gains tax on the inflation adjusted gain of Rs 1,000 (Rs 3,000-Rs 2,000).

Inflation hit

Interest from fixed deposits is also impacted by inflation. Unknown to the FD investor, inflation quietly dents the ability of the invested money to buy various items in the future. So, if you are getting 7% as interest from the FD annually and the annual inflation rate is 5%. Your money is effectively growing at 1.90% after adjusting for the impact of inflation.

Given the impact of inflation and tax on FDs, what investment should an investor consider for needs likely to arise in 3-4 years? We would like to suggest close-ended debt funds like fixed maturity plans or FMPs, offered by mutual funds. Before we discuss their advantages, here is a primer on FMPs.

FMP Primer

FMPs are closed-ended debt mutual fund schemes. They mature at a predetermined date, say, one, three or five years. Here, the money of investors is invested in debt investments till their maturity. FMPs typically invest your money in government securities, corporate debt and money market instruments. This helps in their objective of providing steady returns over a period of time. Here are two other important features of FMPs.

Available in different maturities

FMPs invest in securities depending on when they are slated to mature. Therefore, an investor can opt for the maturity period that suits his needs.

Lower risk investment

FMPs invest in debt and money market investments and hold them till maturity. As a result, they aren’t significantly affected by any changes in interest rates that typically impact debt funds. Further, since FMPs invest in highly rated securities, the credit risk or the risk of debt investments not returning the money is very low.

 

The FMP Edge Over FDs

Having provided you with a primer on FMPs, let’s now take a look at the compelling reasons to actively consider FMPs for needs typically arising in 3-4 years.

Lower tax impact

Like all debt mutual fund investments, returns from FMPs are in the form of capital gains. Since an FMP is a debt investment, for those in the highest income tax slab, and who can stay invested for 3 year or more, they can benefit from twin tax advantages of lower tax rate of 20% and inflation indexation. This gives FMPs an edge in taxation over FDs even if both were to be providing identical annual return for an investment of Rs 1 lakh.

Suppose an FD offers an interest rate of 9% annually but is compounded quarterly. This effectively means an interest rate of 9.3%. While a three year FMP providing 9% annual return will have a maturity value of Rs 1,28,102, it will be Rs 1,21,423 for the bank FD. This is assuming that the investor is in the highest 30% tax slab. Thanks to tax efficiency. FMPs still help save an additional amount of Rs 6,679 compared to an FD despite the FD delivering higher effective returns due to quarterly compounded interest.

It is not uncommon to find FMPs providing higher post-tax returns compared to FDs, liquid funds and debt funds like ultra-short-term debt funds. At the same time, it is important to remember that like other debt funds, an investment period of less than 3 years means that capital gains get added to the income and taxed according to the relevant tax rate.

Effectively combats inflation

The facility of adjusting the capital gains for the impact of inflation, ensures that less of your money goes away from your hand.

Relatively stable returns

As we have mentioned, since FMP investments are held till maturity, you get the benefit of relatively stable returns. This means unlike other debt funds, the scope of fluctuations in maturity amounts at the end of tenure is far lesser. This also makes an FMP an attractive alternative to bank FDs for tenures of 3-4 years.

Therefore, it is fair to say that FMPs provide you with the relative stability of returns that investors seek even as they deal with the twin limitations of FDs in the form of impact of inflation and tax.

Use FMP Features To Enhance Your Advantage

Dividend or growth option according to need

FMPs provide dividend and growth options. If you are not looking for regular income, opt for the growth variant. You will get lesser amount in hand with the dividend option. Dividends first get taxed at 28.84% and then are tax-free in your hands.

Use roll over option to extended tenure

You can re-invest in FMPs on maturity. You can do so using the roll over option offered by fund houses that allows extension for another 1-2 years. A situation like this may arise when you don’t need the money even after maturity. For instance, you decide to postpone the purchase of your home and don’t need home down payment money now.

The extension of the investment allows investors to benefit from favourable interest rate movements besides receiving the usual tax advantage. This ensures that investors don’t have to redeem and re-enter a new FMP. Of course, before you decide to use the roll over option, be sure that you will not need the money during the extended period since you can liquidate your investment only through the stock exchange.

Premature exit through stock exchange

The Securities and Exchange Board (SEBI) has made it compulsory for FMPs to be listed on stock exchanges. If you want to liquidate your investment before maturity, you can sell the FMP through the stock exchange route. However, to get the most out of FMP, it’s best to stay invested in the FMP till its maturity.

In conclusion, it is worth mentioning that your investments for your short term needs require as much of your attention as your long term ones. Thanks to closed-ended debt funds like FMPs, your search for the right investment need not stop at an FD. With its numerous features like tax efficiency and broadly stable returns, FMPs provide you can look for rewarding.

To know about your risk appetite, use our Risk Analyser calculator. Click here

To learn more about closed-end debt funds, Click here

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Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.