The Hindu Business Line : Fixed maturity plans: Managing interest rate risks through them

FIXED maturity plans that most fund-houses offer under their umbrella of bond funds have largely gone unnoticed. Or at least, these plans are not as aggressively marketed as the floating-rate bond funds. That is, indeed, surprising because FMPs help retail investors better achieve their investment objectives. The reason is that such funds are styled to protect investors from interest rate risk.

If anything, this is the only class of investment in the market that helps duration-matching interest-sensitive liabilities. Fund-houses would do well to introduce such products across the yield curve. Importantly, fund-houses should ensure that the asset size of FMPs is optimal with non-concentrated unit-holder ownership.

Duration management: Economically speaking, investment is postponement of current consumption. Logically then, retail investors invest to meet cash outflows in the future. This could be college-level education fee for the children or marriage expenses.

Empirical evidence shows that asset allocation is an important step in the investment process. So, investment has to be proportioned between stocks and bonds. There in lies the problem. Traditional bond funds run a high interest rate risk. These funds invest in bonds of varying maturity. Suppose an investor with a 5-year investment horizon buys units in a bond fund. In year five, the investor has to redeem the units at the then net asset value (NAV). What if bond prices decline during that period because of expectation of rate hike? The NAV will decline sharply, which means that the investor may well fall short of his or her investment objective.

Banks typically hedge their interest rate risk by duration-matching liabilities. But they have an advantage is that both their assets and liabilities are sensitive to interest rates. For retail investors, not all liabilities are sensitive to interest rates. Education cost, for instance, may rise due to other factors. So, a retail investor may not achieve his or her investment objective even if the assets are duration-matched. But that is the risk he or she always is exposed to. FMPs are meant to hedges only the interest rate risk.

Fixed maturity plans: The FMPs have a definitive life and style their investment accordingly. A FMP with a five-year maturity, for instance, will invest only in five-year bonds. Because the bonds will be due for redemption on the day the FMP's life ends, the redemption value of the bond will be equal to its market price. The investor will know this price at the time of buying units in the FMP. So, investments can be made according to the future cash flow needs.

A caveat. Because of the restrictive portfolio strategy, raw returns may be lower than in the case of traditional bond funds. The risk-adjusted returns could be higher but that depends on the market conditions and the ability of the portfolio manager. That is the trade-off retail investors have to make to hedge their interest rate risk.

Concerns: While the mutual fund industry has recognised the importance of introducing thr FMPs, no one has really addressed the concerns of long-term investors. Prudential ICICI, for instance, manages the FMPs that carry an average portfolio maturity of 90, 182 and 379 days. A liquid fund could provide the same level of short-term hedge as Prudential ICICI's FMP.

Fund-houses should instead offer FMPs that invest in the medium-term and long-term maturity buckets. That way, retail investors can easily duration-match their long-term cash outflow requirement. Kotak Mahindra, which popularized this concept, offers such a choice through its Serial Plans. Unfortunately, the asset size of such plans is not optimal.

The 2019 Serial Plan, for instance, has an asset size of just Rs 1.43 crore. Such small asset size does not provide enough room for the portfolio manager to time the market. Fund-houses should, perhaps, tout the benefits of FMPs to attract more investors. The mutual fund industry would have then done a good service to the investors.

(Feedback can be sent to bvenky@thehindu.co.in)

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