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If you’re a less-than-3-year investor, it’s fixed deposits which now score over FMPs
Fixed maturity plans have lost some of their lustre following this year’s Budget. How do they stack up now against the alternative − fixed deposits? A comparison of the pros and cons of fixed deposits versus FMPs can help you choose which product to invest in.
Basics and structure
A fixed deposit is a simple instrument: all you do is deposit money with a bank for the desired time period – a few months, a year, two years, or five. The bank pays a fixed interest rate on the deposit. You can either have the interest paid out regularly, or allow it to compound over the entire tenure of the deposit and receive both the interest and the principal on maturity.
On the other hand, FMPs are closed-ended funds of various tenors – 369 days, 542 days, 1,100 days, you name it. Investments in FMPs are possible at the time of the fund offer alone. In an FMP, too, you have options with respect to dividend payout. But the dividends are subject to dividend distribution tax and there’s no compulsion for them to be paid regularly either.
So you can find both deposits and FMPs that fit into your investment horizon and are locked in for that time period. Now, neither an FD nor an FMP is meant to be particularly liquid. But a deposit can, should the need arise, still be broken and the funds accessed after paying a penalty. On the other hand, while an FMP can be theoretically sold on the stock exchange, in practice, pulling out of an FMP before maturity is not possible.
An FMP fund manager invests across debt instruments issued by banks, financial institutions and companies. Usually, the maturity profile of these instruments closely matches that of the FMP itself. At the time of the fund offer, an explanation of the types of instruments that will be invested in, a break-up of how much of the portfolio will be put in each segment and the minimum credit rating of instruments that the fund will look at may be explained. The aim of an FMP would be to generate returns superior to an FD through a combination of interest accrual and bond price appreciation.
But even so, actual returns can differ from the indicative yields that are ‘informally’ given at the time of a fund’s launch. If the fund manager happens to read the interest rate cycle wrong, or times the investments incorrectly, returns may suffer. If investments are made in higher credit-risk companies and they default, returns can take a blow. Sticking to fund houses that have a consistent record of good performance may address some of this risk.
In this aspect, FDs beats FMPs by a mile, being among the safest instruments around. Interest rates are known beforehand and are steadily paid on time. Deposits up to ₹1 lakh are also insured.
Following the tweaks made in the recent Budget, FMPs held for over three years qualify as long-term capital gains and are liable to be taxed at 20 per cent, with indexation benefits. Shorter holding periods attract short-term capital gains tax, which is levied at income tax slab rates. FDs are taxed at these slab rates.
That brings FMPs of one- to three-year timeframes in line with FDs as far as taxes go. Until the Budget revision, FMPs scored over FDs in terms of returns. But which one suits you now?
The bottomline
For holding periods of over three years, FMPs still win over FDs, especially for those in the 20 and 30 per cent tax brackets. With indexation benefit, even if inflation moderates sharply in the next few years, FMPs will still attract much lower tax than FDs. This compensates for the higher uncertainties in FMPs.
For example, the best interest rate on an FD of over three years tenure is 9.25 per cent currently. Post-tax, this could drop to about 6.6 to 8.4 per cent, depending on your tax bracket. If an FMP only just equals this return, assuming that inflation persists at current levels, post-tax returns could rise above 9 per cent even in the 10 per cent tax bracket. Should inflation drop to the targeted 6 per cent in the next few years, the indexation benefit may still maintain FMP returns above that of FDs in higher tax brackets.
But for investments with one- to three-year timeframes, FDs are a better bet.
The best rate on FDs of one- to three-year tenors is 9.1 to 9.4 per cent, with no risk. In the past, shorter-term FMPs have averaged around 9 to 10 per cent returns. But with the tax advantage stripped away, the returns of FMPs are hardly superior and involve more risk.
Of course, FMPs can invest in instruments bearing higher credit risk and offering higher interest rates, and still attract returns higher than can be earned from FDs. But if your aim is to take only a little risk for FD-beating returns, such a strategy may not suit your purpose.
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