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Are FMPs A Ticking Time Bomb? Watch Out

Are FMPs A Ticking Time Bomb
Mutual funds (MF), taking advantage of rising interest rates, have been launching fixed maturity plans (FMPs) almost every week to attract investors. FMPs are closed-end debt funds that aim to protect the downside. But, to beat competitors, some FMPs are taking undue risks. Market sources told Outlook Money that one FMP launched by a large public-sector MF recently got into trouble with one of its underlying instruments. The company in whose debt paper this FMP had invested in, defaulted on the principal payment. Eventually, the MF’s parent company—one of India’s biggest financial houses—had to bail out the fund. 

Beware of credit risk. Credit risk denotes the quality of your scheme’s underlying instruments and their ability to repay the interest and principal amounts. Whenever your FMP invests its corpus in debt papers of various companies, it hopes that when the tenures end, it gets the money back and pays them back to you—the investor. 

But what happens if one of these companies defaults? There’s a good chance that your FMP might also default and you may not get the yield that was indicated to you at the time of investment. Typically, FMPs roll over such debts into a forthcoming FMP and, in the interim, borrow money to repay existing unitholders. 

Here’s how a typical FMP works. Companies borrow money from banks and financial institutions to meet their day-to-day needs. They also borrow from MFs by regularly issuing debt instruments such as certificates of deposit or commercial papers. These MFs then invest their funds—that they collect through FMPs—in such papers and stay invested in them till maturity. The higher the scrip’s credit rating, the lower the yield it fetches the FMP, and vice-versa. 

When these scrips mature, the companies repay the MFs that, in turn, redeem the FMPs. If, however, a company is unable to repay the loan, this particular scrip is rolled over to another FMP that the MF would have just launched, or will launch soon. In other words, this scrip would then start to appear in the portfolio of the second FMP. The MF, meanwhile, borrows the shortfall from the market and ensures that the first FMP’s redemption doesn’t take a hit. 

Bitter truth. Many FMPs have taken high exposures to the real estate sector. The slump in this sector has resulted in many companies defaulting and, thus, landing MFs in a repayment soup. The MF—about whom the market is abuzz with rumours—denied the problem. The reality is many FMPs, including this one, have taken additional risks to offer that extra bit of return. 

For example, as per the LIC MF’s March 2008-end portfolio published in the newspapers, many of its FMPs have exposures to the real estate and construction sectors. LIC MF FMP Series 35 had invested a whopping 86 per cent in just the construction sector. What’s more, 37.7 per cent of its corpus was invested in assets whose credit rating was below AA—OLM’s threshold of safe investments. This is just one example. There are several FMPs in the market that invest in low-rated scrips and put themselves and your money at risk. The problem is compounded as most of these FMPs disclose their portfolios only twice a year—the minimum mandate by the Securities and Exchange Board of India. 

What should you do? Don’t get swayed by higher indicative yields. Apart from these being just indicative—and not a guarantee—higher the yield, higher is the amount of risk your FMP could be taking to earn that yield. 

Also, look at your MF’s pedigree. “It’s always better to sacrifice a little bit of return if you are offered a quality portfolio,” says Santosh Kamat, CIO (fixed income), Franklin Templeton MF. FMPs are low-risk instruments and capital protection is important. 

Although most MFs disclose portfolios of all their schemes every month, they stick to the bare minimum when it comes to FMPs. This is woefully inadequate as MFs have already shown their capability for frequent disclosures. If FMPs disclose their portfolios every month, it would give an idea to the investor about the credit quality that the MF is used to taking. Also, FMPs must mention in their offer documents the lowest bar in terms of credit quality they are willing to take.