Why FMPs are losing their old shine - for corporates

Global economic uncertainty coupled with some structural issues faced by the Indian economy and a shaky stock market should ideally lead investors towards debt-oriented mutual funds. Fixed maturity plans (FMPs), which offer tax indexation benefits and take most of the risk out of debt fund investing, should have been the flavour of the season.

They were. Till March this year, FMPs were easily the flavour of the season as they offered better post-tax yields compared to fixed deposits. However, it looks like large investors and corporates, which are the biggest category of investors in FMPs, are falling out of love with these debt instruments. An Economic Times article today pointed out that declining surpluses over the past few months have forced corporate investors to cut back on their investments in FMPs. Moreover, short-term rates have declined from 11.5 percent a few months ago to about 9.15 percent at present.

The prime USP of fixed maturity plans has always been their double indexation benefits. Indexation is adjusting the cost of acquisition for the rise in inflation. An FMP invested in in the last week of March and redeemed in April of the following year will face practically no tax in view of the benefit of cost indexation for two financial years.

For example, the cost inflation index number put out by the tax authorities for 2009-10 was 632 and in 2011-12 it was 785 - a gain of 24 percent. This means if you had invested in an FMP in March 2009 and exited in April 2011, your cost is taken as 24 percent higher and you would have paid almost no tax since there is no capital gain after indexation - assuming your FMP returned around 20-22 percent during the period. The 20-22 percent return is thus tax-free, even though it was invested for just over 12 months. It is usually the big corporates that invest hefty amounts to benefit from the tax advantage.

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So have the biggies found better investment avenues or are they just afraid of the new Direct Taxes Code which could take away these double-indexation benefits?

If interest rates are high, corporate and government bond yields also rise. Currently 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. So it may just be possible that corporates are eying government bond yields in the longer maturity bracket.

Secondly, once the Direct Tax Code comes in, the benefit of double indexation could be withdrawn. Under DTC, long-term capital gains from equity or equity-linked schemes will continue to be tax-free but long-term capital gains on non-equity MFs will be taxable at the relevant slabs applicable - though indexation benefits will still be available with more stringent norms.