FMPs: Beware of the credit risk

For some time now, FMPs (fixed maturity plans) have become a regular feature in the investor’s portfolio. In particular, FMPs have found favour with the investor with a low risk appetite. While FMPs have always had an element of risk, until now it was largely restricted to the actual yield (return), which can vary from the indicative yield mentioned at the time of launch. Now FMPs could be exposed to another risk – credit risk.

Before elaborating more on the credit risk associated with FMPs, let’s first understand how FMPs work and the value they can add to the investor’s portfolio.

How FMPs work
FMPs target a pre-defined yield (return). To achieve this, they lock in the same at the time of investing and stay invested till maturity. In turn, investors who stay invested in the FMP till maturity are virtually assured of clocking the given return.

Actual returns could vary
The yield on the FMP mentioned by the fund house at the time of launch is at best indicative. Being market-linked, there can be no guarantee that the FMP will attain that return. Hence, some deviation from the indicative returns cannot be ruled out.

Scenario is changing
FMPs are still being launched in the same fashion like they were launched earlier. So what has changed? Put simply, the investment scenario has changed dramatically over the last few months. As a result, the characteristics of the FMP’s investments have also undergone some changes.

Credit risk
Apart from the risk of earning less than the indicative yield, there is another risk i.e. credit risk that investors must be wary of, particularly in the present investment environment. The credit risk on an investment is the risk of loss due to non-payment of the principal or interest (coupon) or both. Fund houses have taken note of the escalation in credit risk, which explains why some FMPs have started declaring upfront that they will not have investments in certain sectors like real estate, broking and non-banking finance companies (NBFCs).

What investors must do
Investors on their part would do well to take cognizance of the higher risks in FMPs while making an investment decision. While we are not implying that investors hit the panic button and shun FMPs or redeem their existing investments; nonetheless, they need to be conscious of the risks associated with an investment.

For instance, before investing in FMPs investors must consider a few points:

1. At present, some FMPs with an investment tenure of 1-Yr are offering an indicative yield in the 10.00%-10.50% range.

2. Several banks/institutions are offering fixed deposits (FDs) in the 9.00%-9.50% range for a comparable tenure. Most of these FDs have the highest credit rating i.e. minimal risk.

3. Apart from the attractive coupon yield, for the investor in the highest tax bracket, FMPs also offer a superior post-tax return vis-à-vis FDs. Clearly, if return is the parameter being considered, FMPs have an edge over FDs. However, the investor is also taking on higher risk by investing in market-linked avenues like FMPs.

In our view, so long as the investor is comfortable with the idea of taking on that additional degree of risk to clock a higher return, he can consider investing in FMPs. However, if the investor does not want to take on that extra risk and expects to be invested in an avenue offering assured returns, FDs are more suitable.