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Monday, December 3, 2012

Understanding the risks in FMP

Risks in FMP are to be understood clearly before we start investing:
Default Risk : Bank Fixed deposits are considered less risky, as the depositors do not take the risks on the investments and loans created out of the deposited funds. The risk is transferred to the Bank. In case of FMP, the money is as good as the investment generated out of the funds. Here risk is retained.
Liquidity risk : Normally Banks, permit you to terminate the contract prematurely, at their own discretion, to maintain an image of liquidity and to satisfy the depositor. In case of FMP, it is closed ended mutual fund and hence can be carried till maturity. There are provisions to get them listed in the stock exchanges, to provide liquidity. However such listings do not guarantee liquidity, as there may not be takers.
Still, FMP is a good investment, if you do not need the money before the maturity date, as the provide better returns than the fixed deposit in bank. The default risk is minimised by the Fund manager by investing in the debt instruments which have a highest/higher ratings. A  13 month FMP, minimises the default risk as the tenure is shorter and rating downgrades on the investment is almost NIL during such a short period. It is imperative to read the offer documents to know where your fund proposes to invest. If investments are to be made in highest rated instruments, then you can consider the default risk to be almost zero.
To offset the liquidity risk, invest only such monies which you do not need for the prescribed period. Through this process, you can eliminate the liquidity risk.
Despite these apparent shortcomings, in the Indian context, the biggest attraction in FMPs are TAX TREATMENT. The income from fixed deposit is considered as your income  for the purpose of taxation and tax will be deducted at source, in case income exceeds the prescribed limit in a financial year. In case FMP, in a growth scheme, the return is treated as gains from short term/long term investments ( depending on the period of holding) and accordingly taxed. You  can choose the indexation benefit and can lower your taxation. This results in better yield on the investments. Many of the high tax bracket individuals prefer the taxation advantage over the risks outlined, which can be minimised substantially.
We will amplify the taxation advantage in our next post.