The Hindu Business Line : Debt funds that help you take the plunge

With fixed maturity plans now positioned to attract retail investors too, funds have also lined up a slew of capital protection products, which they hope will succeed in drawing the conformist investor.

If you are a conservative investor, you may be dismayed at the shrinking options in the debt space. At a time when interest rates are edging up, the bank fixed deposit appears to be the only option that offers an attractive yield, post-tax. But that is only if you consider conventional savings options. It may be time for the conservative to cross over to the world of debt mutual funds, with new products designed for a more risk-averse investor launched almost every day.

Fixed maturity plans (FMPs), which earlier found favour with institutional investors, now appear attractive to retail investors too. Funds have also lined up a slew of capital protection products, which they hope will succeed in drawing the conformist investor.

Here is a look at what these funds offer, beginning with FMPs.

FMP versus small-savings

FMPs are close-ended and therefore, have a fixed time horizon. These funds invest in a basket of debt securities that mature at the end of its horizon. For instance, a one-year FMP will invest in securities that mature at the end of a year. The funds are relatively passively managed and securities held till maturity. Investors get an idea of the likely yield on their investment at the time of entry.

This is not too different from a bank deposit. However, the realised yield could be slightly different from the yield indicated at the opening of the offer. This is because cash flows from the portfolio may be re-invested at different rates from that of the securities' coupon rate. Your return is not assured, unlike in a bank deposit or a small-savings scheme.

Still, investors well-versed with the concept of fixed-period investing may be more comfortable investing in these products than open-end debt funds, where there is no time-line to maturity. FMPs ought to ideally deliver higher returns than a bank deposit as they invest in more high-yielding debt securities.

Most FMPs try to pay dividends annually to cater to investors seeking regular income, but there is no promise of such a payout. The option of redeeming investments before maturity comes with a stiff exit load. FMPs are offered at various maturities ranging from three months to five years. However, recent launches have been for shorter maturitiea, as realised yields have been better in the short term.

For investors seeking a target return over a period, FMPs are a more suitable option within the debt fund space. As such plans have a fixed horizon and hold securities till maturity, they may better manage interest rate risks than open-ended debt funds; such risks are the changes that occur to a bond's value on account of movements in interest rates.

Less risky

For instance, when interest rates rise, the market value of the securities fall, as buyers are willing to pay less for a bond that yields an interest rate lower than the prevailing rate. Also, the longer the time to maturity, the more sensitive is the market value to interest rate changes.

These fluctuations in market value do not affect your returns from FMPs as securities in the portfolio are not traded. At the time of redemption, the securities held in the portfolio mature. You are more certain, therefore, of achieving your target return for the period of investment when investing in an FMP than you would be in an open-ended debt fund.

More tax-efficient

On a post-tax basis, several FMPs now offer a better yield than a fixed deposit for periods less than a year. Investors at the higher end of the tax bracket might find FMPs attractive, even for longer tenures. This is because gains from holding an FMP for longer than a year are subject to capital gains tax of 10 per cent or 20 per cent on indexation. Interest from deposits and small savings is, on the other hand, taxed at the marginal rate. Also, only sums up to Rs 1 lakh are exempt from tax. This makes FMPs a better option for deposits of higher amounts.

A dash of equity

Some long-term FMPs now provide investors a taste of equity by allocating a small portion of the portfolio to stocks. These are suitable for investors with a higher risk appetite.

Interestingly, such FMPs closely resemble "capital protection" products — the latest category to hit the market after the Securities and Exchange Board of India (SEBI) allowed them a month ago.

Capital protection schemes with their focus on safety first, as opposed to maximising investment returns, suit conservative investors. Franklin Templeton Mutual Fund and Reliance Mutual Fund have both filed draft offer documents with SEBI for the launch of such products.

Protection-oriented

Capital protection products do not assure or guarantee capital or returns. In adherence to the newly drafted regulations, they will be positioned as "protection-oriented" funds. Essentially, these funds will endeavour to protect your capital, even as they take exposure to riskier assets. They do this by investing in securities rated AAA, which denote highest safety. SEBI requires the portfolios of such funds to be rated by an approved rating agency such as CRISIL or ICRA.

The rating will indicate the degree of certainty with which the fund will meet its objective of capital protection. It will not rate the stability of a fund's net asset value, which will determine your ultimate returns. The three funds in the pipeline have received an AAA SO (Structured Obligation) rating, which means the asset management company concerned will step in, in the event of default.

The funds proposed to be launched in this category are essentially a simplified version of structured products targeted at high net worth individuals overseas. Investments will be made in high quality debt, which typically commands lower yields. But by investing in such securities where the return of capital on maturity is more or less assured, fund managers are able to take a small exposure to a more risky asset, such as equity. For it to work, however, no withdrawals can be made throughout the period.

Franklin Templeton is planning to launch "Franklin Templeton Capital Protection Oriented" fund in two plans — three years and five years. The three-year plan will have an 80 per cent allocation to debt and 20 per cent allocation to equity. In the five-year plan, the allocation can go up to 30 per cent. Reliance Mutual has lined up Reliance Capital Shield and Reliance Capital Protection Fund, along similar lines.

How will they work?

For instance, if you invest Rs 100 in the five-year plan of the proposed fund from Franklin Templeton. The fund manager will invest Rs 70 of your money in quality AAA-rated debt securities, such that the investment grows to at least Rs 100 at the end of five years. This way your capital is intact. The rating of its portfolio will be done on periodically and the fund will ensure that it gears its portfolio towards meeting the capital protection objective. The remaining Rs 30 is invested in equity. Equity tends to be volatile in the short term. Over a five-year period, however, it is reasonable to expect a modest return from equity. Even if equity returns nothing, you still have your capital intact.

It is possible that you might achieve similar returns by investing 70 per cent of your assets in a bank deposit and the rest in equity. However, capital protection products still hold a tax advantage over deposits.

Should you invest?

As both fixed maturity plans and capital protection products are close-ended, opting for long tenures in these products would mean locking in your investment at current yields. This is not so much of an issue now as yields are higher than they were, say, two years ago. If you expect interest rates to go up further, you can opt for shorter tenures in the FMP series.

Every FMP has a unique maturity profile and different yields. Comparisons can be made of the indicative yields across FMPs and bank deposits, but this could prove challenging. Also, a plan that projects a higher yield is probably taking on more risks.

For those who fancy hybrid debt plans that invest in equity, capital protection products might be a better option than monthly income plans (MIPs) and debt-oriented balanced funds, which have a similar asset allocation profile. While MIPs have delivered a higher return than long-term debt funds over the past three years, their track record has not been good when the equity market has been volatile or at times when interest rates declined.

Capital protection might, however, work better only when yields are high. In a declining interest rate regime, preserving capital would call for a lower allocation to risky assets.

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