Before the challenges emerged in the MF industry following the IL&FS crisis, FMPs were considered largely safe and a good substitute for bank FDs. Just as bank FDs declare the offered interest rate, the initial yield to maturity of the portfolio gives an idea of the indicative return of the scheme.
As FMPs are close-ended instruments, they generally hold investments until maturity. This eliminates the interest rate risk; however, credit risk does exist. Credit risk is the possibility of the borrower not returning the money.
Not all FMPs are the same: Different FMPs take different degrees of risk
While the industry launches FMPs that purely invest in high rated papers, it also offers FMPs, which take exposure to lower quality debt. You can identify the likely credit quality of an FMP by looking at the investment strategy shared in the SID. If the investment strategy says that the fund can invest in AA rated instruments, recommend them only to clients having moderate risk appetite. The indicative returns of FMPs having exposure to lower rated paper are comparatively higher and so are the risks.
FMPs tend to run concentrated portfolios: upping the risk
Analysis of FMPs having exposure to Zee backed securities showed that while the schemes per security exposure was below 10% (as per SEBI mandate), the group level exposure was over 10% in many cases. As FMPs do not face daily redemption pressure, mutual funds can take concentrated bets in these schemes. In such a scenario, if a group like IL&FS or Zee default, they eat away a large chunk of the gains.
Liquidity is an issue
While FMPS are listed in stock exchanges, the demand for them in secondary markets is almost non-existent. Unlike banks where you can break your FD by paying a penalty, this option is limited in case of an FMP.
So, should investors move back to bank FDs? Are they the risk-free choice? Of course not. While bank FDs tend to be safer, failures have happened in the banking space too.
A sneak-peek into the history of banking in India shows that 665 banks closed between 1947 and 1969, according to an article published in Livemint. While the cases of such defaults have reduced substantially, there are examples such as Shivajirao Bhosale Sahakari Bank (Pune) and Kapol Bank recently restricted withdrawals.
While Deposit Insurance and Credit Guarantee Corporation does insure investor’s bank deposits, it is limited to Rs.1 lakh. So even when your clients invest in a bank FD they need to check the health of the bank.
Overall, when it comes to investments, risks exist in all financial instruments be it equity or fixed income. Now, if your clients have low risk appetite, recommend FDs of banks having good track record and FMPs investing in AAA rated instruments only.
