Saturday, September 10, 2011

Deciding between Fixed Deposits and Fixed Maturity Plans

There is a lot of news, information and advertisements about Fixed Maturity Plans offered by Mutual Fund companies. As an investor you must have come across this dilemma as to what to choose from – a Fixed Maturity Plan (FMP) offered by a mutual fund house, or a Fixed Deposit (FD). Well it’s confusing for an investor because both of them start with the word ‘Fixed’. So, now let us understand what exactly a FMP is and how it is different from a FD.
A Fixed Maturity Plan is a close-ended fund that invests in debt and money market instruments of similar maturity as the stated maturity of the plan. That means a 90 day FMP will invests in debt and money market instruments which mature in 90 days like 3-month Certificate of Deposits (CDs), 3-month Commercial Papers (CPs) etc. An interesting point to be noted here is that unlike a FD where your maturity amount is fixed, in a FMP only the period or time horizon of the fund is fixed. As such a 90-day FMP will cease to exist on maturity.

The distinguishing feature of a FMP is its indicative return unlike a FD where you know the fixed amount receivable at the end of the maturity period of your FD. So a 90-day FMP at a time where 3 month instruments are yielding 8.0% p.a. does not mean that you will get assured returns of 8.0% p.a., but it is just an indicative yield that highlights the return generating potential of the instrument.

You might say then ‘why I should opt for a FMP where the returns are just indicative and not fixed?’ FMPs are not all that bad as they seem. The tax implication on FMPs gives it a leg-up over a FD. The tax implication on FMPs depends on the investment option one chooses – dividend or growth.In case of dividend option, investors have to bear the Dividend Distribution Tax (DDT) of 13.84%. Whereas in case of growth option, returns generated are treated as capital gains and taxed accordingly. Thus, in case of short-term capital gains (i.e. if investments are held for less than 365 days); the interest income is added to the investor’s income and is taxed at the marginal rate of tax. And where investments are held for more than 365 days (long-term capital gains) the tax liability is computed using two methods i.e. with indexation (charged at 20% plus surcharge and cess) and without indexation (charged at 10% plus surcharge and cess); the tax liability will be the lower of the two.

In a nutshell

FMPs are superior to FDs in terms of post-tax returns. However, before investing please ensure you have the right risk appetite for a FMP as said earlier there are no assured returns in a FMP unlike a FD. Also in case of bank fixed deposits, the Deposit Insurance and Credit Guarantee Corporation of India (DICGCI) guarantees repayment of 1 lakh in case of default. There is no such guarantee offered in company deposits and the safety of your deposit depends on the financial position of the company.

1) In FDs the rate of return is fixed, while in FMPs the period of maturity is fixed
2) Returns on FMPs are not guaranteed while FDs offer guaranteed returns. But only bank FDs are guaranteed with repayment of 1 lakh in case of default, while in case of company FDs, the safety depends on the credibility of the company
3) If you fall in the highest tax slab and want to invest in a FMP with tenure of over 1 year, then investment in Growth option will help you enjoy high post tax returns
4) Similarly if you invest in a FMP with tenure of less than 1 year, then investment in Dividend option will help you enjoy high post tax returns

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1 comment:

  1. Nice article. I want to invest in a fixed income instrument for 3 months. Do you advice FMP or Fixed Deposit?