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Context
Kotak Mutual Fund and HDFC mutual fund informed investors in its Fixed Maturity Plans (FMPs) that it would not be able to redeem one of its FMPs schemes on time.
What is the fixed maturity plan
- Fixed Maturity Plans are offered by mutual funds (MFs). It is a type of debt mutual fund.
- Debt mutual funds, unlike equity MFs, invest in debt securities issued by companies (both publicly listed and privately held) and governments.
- FMPs, in turn, are a class of debt funds that are close-ended: one can only invest in them at the time of a new fund offer and they come with a specified maturity date, much like a fixed deposit (FD).
- FMPs invest in debt having different levels of risk. But they usually stick to relatively low-risk debt issues.
Benefits of fixed maturity plan
- Fixed Tenure: The maturity period of FMP is fixed and investment is essentially locked-in till maturity. The maturity period of FMPs is usually more than 3 years from the date of unit allocation.
- Close-ended Schemes: This means that one can invest in the scheme only during the New Fund Offer (NFO) period of the scheme. After completion of the NFO period, no additional investment can be made by investors
- Low-Interest Rate Sensitivity: A majority of the investments made by these schemes are held till maturity hence FMPs tend to feature low levels of interest rate sensitivity.
- Dividend: The dividend received from an FMP is tax-free.
- Taxation benefit: FMPs offer better post-tax returns than FDs because they offer indexation benefits. Indexation benefits linked to capital gains, as opposed to tax on interest income in the case of an FD. Indexation helps to lower capital gains and thus lower the tax.
- Credit Risk: Owing to the fact that Fixed Maturity Plans invest mostly in highly rated credit instruments, the risk of default is minimized.
Limitation of fixed maturity plan
- Low Liquidity: Since redemption of scheme units cannot be made prior to the maturity of the FMP schemes, these funds have potentially low levels of liquidity.
- Locked-In Rates: While locked-in rates are an excellent choice during a falling interest rates regime, the same can become a problem during a period of rising interest rates. When market rates move upwards, locked-in rates can lead to missed opportunities with respect to potentially higher returns coupled with possibly lower risk levels.
- Returns Not Guaranteed: Returns from FMPs are not guaranteed unlike other fixed return instruments such as fixed deposits. FMPs are market-linked and low potential risk does not mean zero risks for the investors. There is always the possibility that the company issuing the debt would not be able to repay the principal amount.
For example, recently, many FMPs had invested their money in debt issued by real estate companies that were considered very safe. Suddenly, the market scenario has changed, and many supposedly “safe” real estate companies are feared to have defaulted on their debt repayments and redemptions
The recent case of Kotak and HDFC FMP schemes
- Some mutual fund companies which had lent to Zee (Essel) Group entities are holding back payments due to investors in their fixed maturity plans (FMP).
- Several FMPs that are due for maturity are not able to repay the entire amount. This is because of the delay in recovery from the Zee Group.
- Investors in six FMPs of Kotak MF will not be able to redeem the entire maturity value. HDFC Mutual Fund has also informed investors its plan to extend the tenure for one of its FMPs coming up for maturity by another year.
Issues involved
- Inadequacy of credit ratings: Credit rating agencies failed to assess the credit risk involved with the Essel group highlight their inadequacy
- Role of Asset management companies: Financial health of Essel Group deteriorate in January but Asset Management Companies (AMCs) informed their investors of their inability to repay the proceeds just before the maturity date. Earlier intimation would have allowed investors to plan their finances better.
- Impact investors’ confidence: If a corporate entity defaults on their payment to the investee schemes, it, in turn, takes away the ability of the fund house to honour repayment to investors. This erodes the confidence of investors
- Impact on Economy: According to Moodys, any effects on the NBFCs will spill over to the broader economy mainly through the credit channel because NBFCs are a ‘material provider of credit for the economy’. The slowdown in credit growth provided by NBFCs will hamper overall consumption and economic growth
Way Ahead
- SEBI should evolve a material disclosure regime for mutual funds with standard communication formats and enhance its regulatory regime to overcome such crisis
- Credit rating agencies should assess the standard of corporate governance, the management team and the inherent business model of a company.
- Fund trustee must deliver greater accountability rather than mutely approving AMCs decisions.
Source: https://www.thehindu.com/business/what-went-wrong-with-debt-mfs/article26899434.ece
