Fixed Deposit or Fixed Maturity Plan – Which one to invest in?

Fixed Deposits is the most preferred avenue of saving for Indian households (at least for the white money). These days, there is another investment avenue which is gaining a lot of attention – Fixed Maturity Plans (FMP). Most of us tend to ignore it, either due to misplaced notions about mutual funds or ignorance or fear of venturing into unknown. But, FMPs are slowly growing into a formidable alternative to FDs and are worth considering for your next investment. Here is why.

What are FMPs?
FMPs are the mutual fund houses’ answer to the guarantee and safety of FDs. FMPs are essentially debt mutual funds which are invested in instruments equal to the tenure of the mutual fund. For e.g. If the FMP is for 365 days, it will invest the money in instruments of a similar maturity.
FMPs manage this by being closed-end funds. i.e. they are open for investments only for a short period (say a week). Once the offer closes, it invests the total collection in debt instruments from banks and corporates and t-bills/bonds with maturity that coincides with the maturity of the FMP. At maturity of the FMP, you will receive your principal with interest (just like in an FD).

FMPs are available in various maturities, generally ranging from 30 days to 5 yrs.

What is the dividend option and growth option in FMPs?
These options are a way of classifying your returns.
In case you choose your FMP with the dividend option, the returns will be taxed at the dividend distribution tax (currently 13.84%).
If you choose the growth option and the FMP maturity is less than one year, the income will be taxed at your marginal tax rate.
If you choose the growth option and the FMP maturity is more than one year, you can avail of indexation benefits and taxes will apply accordingly. Read further to know more about indexation benefits.

What is indexation benefit in an FMP?
The indexation here means indexation for inflation. Government of India allows you to factor in cost of rising prices while calculating gains on FMPs (and other mutual fund investments). It releases a cost inflation index every year, for this purpose. Here is how indexation works:
Amount invested in Aug 2012: 10 lacs
Amount redeemed in Aug 2013: 12 Lacs

Cost Inflation Index in 2012: 852; Cost Inflation Index in 2013: 939
Inflation Rate:(939-852)/ 852 = 10%

Hence your principal (10 Lacs) adjusted for inflation becomes 10 Lacs * 10% = 11 lacs
Taxable amount = 12 lacs – 11 lacs = 1 lac while
Interest amount = 12 lacs – 10 lacs = 2 lacs

Thus, indexation benefit in this case reduced your taxable amount by 1 lac Rs.
Amazing. Isn’t it!!

Comparison of FMPs with FDs:

As you can see from the above table, while FDs score over FMPs when it comes to safety and liquidity, FMPs are a much better if you consider returns, thanks mainly to indexation benefit and tax treatment of FMPs.
Let us see how the returns from FMPs stack up against that from FD.
FMP vs FD – money in-hand:
The cost inflation indices used for indexation benefit below are actual figures.
The maturity of both FMP and FD is considered to be 1 yr.
The fund management charge(FMC) for the FMP is assumed to be 0.5%

 

 
 
 
 
 
 
 
 
 
 
 
 
As the indexation rate is 10%(as explained earlier), the taxable amount became zero thanks to the indexation benefit of FMPs.
Thus, assuming equal returns for both FD and FMP, had you invested in an FMP last year, you would have earned an absolute 1.56% higher return on your investment.
If you fall in the higher income tax bracket of 30%, the return would have been 2.59% higher.
So much extra return for so little extra risk(if you see any)
FMPs are best suited for you if:
1. You fall in the 20% or 30% tax bracket
2. It is a high inflation scenario
Currently, not only is it a high inflation environment, yields (interest) on FMPs are also near a 3-yr high (for reasons out of scope of this discussion), thus making FMPs must-have instruments in your debt portfolio.
Just be careful to check the following before choosing your FMP
1. Past yields of FMPs from the fund house
2. Instruments to be invested in (from the offer document of the FMP) – you may choose to invest only in FMPs investing in AAA and AA instruments. One can also check the sectors and avoid ones like airlines/real estate etc. This will help increase the safety quotient of your FMP.
3. FMC (if not mentioned directly in the offer document, check historical) – Higher the FMC lower your net returns.
Thanks!
 
Advertisements

2 comments

  1. D Mehta · November 6, 2014

    Very well explained!!

    Like

  2. prateek maheshwari · July 15, 2014

    Insightful

    Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s