FISCALLY FIT
Know your FMPs
SHYAM P.
|
Debt mutual funds do not always deliver on their indicative returns and may even put your principal at risk.
|
If the above statistic appears like an agricultural nutrient recipe for cultivating high yielding sugarcane, let me assure you that you are not alone. Unfortunately the data represents the investment portfolio of an FMP (Fixed Maturity Plan). FMPs ar
e a popular category of Debt mutual funds that are sold as an alternative to Fixed Deposits (FDs) for their comparative tax advantage.
Debt mutual funds contribute to more than half of the total assets managed by mutual funds in India and FMPs (a subset of debt funds) contribute to 25 per cent of total mutual fund assets. If you own one of these or have received a call to invest in them with claims that “they are same as FDs but give better returns”, then you might want to know that nearly a third of your money invested in these funds is used either to give loans to Finance companies/Real Estate companies (in the form of debentures) or to buy out chunks of loans already disbursed by Banks/Finance companies (in the form of ‘structured obligations’)
Myths and facts
Let me try to clarify some the myths about FMPs and in the process highlight the risks involved in Debt mutual funds as an investment option
Myth1: FMP is same as FD
Reality: Not true. Although both lock your money for a ‘fixed’ period; the similarity ends there. FD offers ‘fixed return’ (interest rate). FMP is a Debt mutual fund that does not promise a fixed return.
Myth2: My FMP will definitely deliver at least the ‘indicative returns’
Reality: Not necessary
Myth3: Safety of principal is always given a higher importance than returns.
Reality: Common! The mutual fund manager gets his bonus based on returns. Moreover isn’t safety a ‘relative’ term? Since most of the fund managers chase returns, the meaning of ‘safety’ has morphed into — not taking too much extra risk than peers (other fund managers).
Myth 4: My FMP invests only in high grade Government and Corporate Bonds or Bank CDs (certificate of deposit)
Reality: Not really. FMPs lend to NBFCs (finance companies) and real estate companies. They also buy out loans ranging from credit card loans to personal loans that are disbursed by finance companies to individuals. In addition, they buy out loans given by Banks or NBFCs.
Confusion: How can loans granted by one bank/finance company be sold to a mutual fund?
Explanation: Not only can loans originated by one bank/finance company be sold to mutual funds, they can also be sold to other banks. In fact such packaging of home loans and selling them to multiple investors and financial institutions around the world is one of the reasons why the collapse of the U.S. housing bubble has had a global impact. A similar process of creating ‘structured obligations’ (packaging and selling of loans) is also prevalent in our country. Here is how it works:
Step 1: Finance company issues ‘sub-prime’ (high risk) personal loan to panwala at 35 per cent annual interest rate to be repaid over two years.
Step 2: Finance company has issued 500 crores of such loans and needs more money so that it can issue more such lucrative loans.
Step 3: Finance company Treasury Head calls Debt fund manager and asks “are you interested in making 20-25 per cent p.a. return on your investment by buying personal loans from us?”
Step 4: Debt Fund Manager: “of course! I can barely get eight per cent p.a. from Government bonds. Can you also throw in some other loans like vehicle loans, credit card loans etc. so that I can buy a diversified portfolio? Make sure you give me ‘prime’ (lower risk) loans too, although they may yield lower interest rate.”
Step 5: Treasury Head: Great! I will create a SPV-Special Purpose Vehicle (a Trust account) into which I will transfer an assorted pool of loans (two wheeler, credit card, personal loan, prime and sub-prime) worth 1000 crores. Pay me 1150 crores upfront (15 per cent profit on 1000 crores) and buy the SPV. I will credit the EMIs collected every month into the SPV, and you can withdraw at your convenience. Although I am charging a 15 per cent mark-up on the loans, you will still make better returns than you would on Government Bonds because the average interest rate inbuilt in the customer EMIs is 20 per cent.
Step 6: Debt Fund Manager: What if the customers default? Will you compensate me?
Step 7: Treasury Head: We have paid a leading credit rating agency to evaluate our loans. They said that only five per cent of these loans will experience customer default, so I will compensate you for loss up to five per cent. With my loss guarantee, the rating agency will give AA grade to the ‘loan package’: meaning high quality investment.
Step 8: Debt Fund Manager: If you have paid lots of money to the rating agency, their rating must be very accurate. The deal seems fair.
Step 9: Finance company uses the payment received by selling its loans at a profit (even before their tenure is over), to give out more loans.
Similar packaging and selling of loans is also done for large loans given to real estate projects. Today, most of the Debt mutual funds in the country have loaded themselves with such loans purchased from finance companies and banks through the ‘structured obligation’ route.
Principal risk
So what is the problem, you may ask? The answer is ‘risk’. To be more specific: the risk of losing your principal.
Loans, particularly personal loans, have witnessed very high default rates in the past few months. One reason is that customers took too much of these loans that were aggressively marketed at high interest rates and are now not able to repay. A similar pattern has been observed in other segments such as credit cards and two wheeler loans.
Now, many debt mutual funds that purchased these loans are stuck with paper on which default rates have become much higher than what was guaranteed by the finance companies. Unfortunately there is no standard market like the stock market for selling these ‘structured obligations’. This means the mutual funds that own these loans will have to retain them until all loans mature, even if the risk of loss increases.
To worsen the situation, large investors and companies that parked their savings in such funds have pressed the ‘sell button’ even before the redemption date is reached, despite the high penalty (around two per cent) involved in doing so. FMPs and other Debt funds that are unable to meet the redemption pressure have approached banks to lend them money to tide over the crisis. Mirae Asset Management Company is a case in point.
The recent turn of events has brought out the uncertainty involved in achieving the ‘stated’ returns in Debt Mutual Funds/FMPs and has exposed the inherent risk of losing a portion of your principal. The winner in this chaos seems to be FD (fixed deposit), which has emerged once again as the safer alternative, untouched by the vagaries of financial engineering.
Check if your fund has invested in ‘structured obligations’ by logging on to www.valueresearchonline.com and clicking the portfolio details of your fund. You can also find out the percentage of money allocated to these instruments, by your fund.
This is a fortnightly column on money matters. You can reach the author at shyamscolumn@gmail.com or www.shyamscolumn.com
Printer friendly
page
Send this article to Friends by
E-Mail
Magazine
