Friday, August 29, 2008

ARE FIXED MATURITY PLANS A TICKING TIME-BOMB?

FMPs are walking a tightrope and amassing credit risk

In an urge to attract investors and taking advantage of the rising interest rates, mutual funds (MF) have been launching fixed maturity plans (FMP) almost every week. But in an attempt to earn a higher yield than its competitors, some FMPs are taking on undue risk. Market sources have told Outlook Money that one FMP launched by a large public-sector MF recently got into trouble with one of its underlying instruments. The company in whose debt paper this FMP had invested in, defaulted on the principal payment and the MF’s parent company – itself one of India’s biggest financial houses – had to bail out the MF.

Beware of credit risk
Credit risk denotes the quality of your scheme’s underlying instruments and their ability repay the interest and principal amounts. Whenever your FMP invests its corpus in debt papers of various companies, it hopes that when the tenures ends, it gets the monies back and pays them back to you – the investor.

But what happens if one of the underlying company defaults? There’s a good chance that your FMP might also default in that case and you may not get the yield that was indicated to you at the time of investment. Typically, FMPs roll-over such bad debts into a forthcoming FMP and in the interim, borrow money to repay the existing FMP unitholders.

Here’s how a typical FMP works. Companies borrow money from several sources like banks and financial institutions to meet their day to day needs. They also borrow from MFs and regularly issue debt instruments like certificate of deposits or commercial papers to MFs. These MFs then invest their monies – that they collect through FMPs - in such papers and stay invested in them till maturity. Higher the scrip’s credit rating, lower the yield it fetches the FMP and vice-versa.

When these scrips mature, the companies pay back to the MFs that in-turn redeems the FMPs and pay the money back to unitholders. If, however, a company is unable to repay the loan, this particular scrip is then rolled over to another FMP that the MF would have just launched or will launch soon. In other words, this scrip would then start to appear in the portfolio of the second FMP. The MF, in the interim, borrows the shortfall from the market and ensures that first FMP’s redemption doesn’t take a hit.

A bitter truth
Many FMPs have taken high exposures to the real-estate sector. The slump in this sector has resulted in many companies defaulting and thus landing the latter in a repayment soup. The MF - about whom the market is abuzz with rumours lately –denied the problem. However, the reality is many FMPs, including our protagonist, have taken on additional risks to offer that extra bit of return.

For example, as per the LIC MF’s March 2008-end portfolio that it published in the newspapers, many of its FMPs have exposures to the real-estate and construction sector. LIC MF FMP Series 35 had invested a whopping 86 per cent to just one sector; construction. 24.66 per cent of this FMP’s corpus was invested in assets whose credit rating was below AA – OLM’s threshold of safe investments. This was just one example; there are several FMPs in the market that invest in low-rated scrips and put themselves – and your money – at considerable risk. The problem is compounded as most of these FMPs disclose their portfolios only twice year – the bare minimum required as per the securities and exchange board of India (Sebi)’s mandate.

What should you do?
Don’t get swayed by higher indicative yields. Apart from these being just indicative – and not a guarantee – higher the yield, higher is the amount of risk your FMP could be taking to earn that yield.

Look also at your MF’s pedigree. “It’s always better to sacrifice a little bit of return, if you are offered a good quality portfolio”, says Santosh Kamat, CIO-fixed income, Franklin Templeton MF. FMPs are low-risk instruments and capital protection is important.

It would also bode well if disclosers are enhanced. Presently MFs are made to disclose their portfolios at least twice a year. Although most MFs disclose portfolios of all their other schemes on a monthly basis, they stick to the bare minimum when it comes to FMPs. This is woefully inadequate as MFs have already shown their capability for frequent disclosures. If FMPs disclose their portfolios on a monthly basis, it would give a good idea to the investor about the credit quality that the MF is used to taking. Additionally, FMPs must mention in their offer documents the lowest bar in terms of credit quality they are willing to take on.

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