Maybe, it's not the time to lock in to FDs and FMPs

By Arjun Parthasarathy

The herd is telling you to invest in fixed maturity plans (FMPs) but if you move away from the herd you will be much better off.

The most obvious investment choice is not the most obvious investment choice. For risk-averse investors, bank fixed deposits (FDs) or mutual funds’ fixed maturity plans (FMPs) offer interest rates of 9 percent or more. Many investors have locked in money at 9 percent or higher rates of interest for periods from three months to three years, with the bulk of the investments being in one year or less maturity products.

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In fact, FMPs account for 30 percent of total mutual fund assets as of June 2011 and, at a total of Rs 1.2 lakh crore, are at a three-year high. Interest rates have moved up by 2.5 percent over the last one year on the back of the Reserve Bank of India raising policy rates to control inflationary expectations, which are trending at over 9 percent levels.

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Fixed income investors have taken advantage of the high rates of interest in the market and have locked in to such rates. At this point of time, with inflation still at higher levels and equity markets not doing too well (Sensex is down by 7 percent in the calendar year to date), locking on to higher rates in fixed deposits or FMPs does seem to be a good idea.

Or is it?

Let us ask ourselves two questions. The first is, if interest rates are high and looking attractive, what about government and corporate bonds yields in the longer maturity bracket? The second is: will interest rates go higher from here or lower?

Answering the first question, corporate bond and government bond yields have also risen due to the rise in interest rates. Five- and 10-year corporate bond yields are at 9.4 percent levels, up by 100-150 basis points (1-1.5 percent) over the last one year while five- and 10-year government bonds are at 8.3 percent levels, up by around 70 basis points over the last one year. Your strategy of locking in to interest rates at 9 percent levels is a way of saying that it is still not time to invest in corporate bonds and government bonds or income and gilt funds.

Will interest rates go higher or lower? Locking in to interest rates implies that you expect interest rates to remain stable and not go higher. If you are wrong, you lose the opportunity of investing at higher levels if interest rates rise. You may even believe interest rates will fall in the next one year and by locking in to higher rates, you benefit if interest rates fall.

But here’s another way to look at it: if you lock in to current rates, you lose if rates go up further. But if rates come down, you would have lost an opportunity to get better returns from corporate and government bonds, or funds that invest in these bonds, which will be giving much higher returns when their prices rise.

The author is editor www.investorsareidiots.com, a financial web site for investors.