Capital protection funds vs fixed maturily plans vs FDs
The main aim of a capital-protection fund is to protect the principal by
investing a part of it in fixed-income instruments such as bonds,
T-bills and certificates of deposits (CDs). The rest is invested in
equities.
If safety of capital is your concern, you would probably think of parking your money in bank fixed deposits (FDs). Though, a smarter option would be to explore mutual fund debt schemes, which offer better tax-adjusted returns without taking too much risk.
In debt mutual funds, the least risky options are capital-protection funds and fixed-maturity plans or FMPs. Both are close-ended schemes where no redemption is allowed before maturity.
THE OBJECTIVES
The main aim of a capital-protection fund is to protect the principal by investing a part of it in fixed-income instruments such as bonds, T-bills and certificates of deposits (CDs). The rest is invested in equities.
"The debt-equity allocation is based on the yield on bonds and the tenure of the scheme," says Puneet Pal, head, fixed income, BNP Paribas Mutual Fund.
Imagine a fund of Rs 100 which invests in debt securities with 10 per cent yield. To protect its capital, it will invest Rs 90.909 in these securities so that this amount becomes Rs 100 (at 10 per cent yield) after a year. The rest, Rs 9.091, will be invested in equity or related instruments.
The value of the equity portion at the end of the tenure will be the gain. If it grows 15 per cent to Rs 10.45, the value of the investment at the end of the tenure will be Rs 110.45, a gain of 10.45 per cent. If the equity portion falls 15 per cent to Rs 7.73, the gain will be 7.73 per cent. "Investors must note that the capital protection offered is not guaranteed but only assured," says Jiju Vidyadharan, director, Funds & Fixed Income Research, Crisil Research.
The Securities and Exchange Board of India has mandated rating of the fund structure by a credit rating agency for assessing the degree of certainty with which the objective of protecting capital can be met.
"The top rating for capital-protection funds is AAA, indicating the highest degree of certainty regarding timely payment of the principal on maturity," says Vidyadharan.
FMPs, on the other hand, generate FD-like returns by investing in bonds and holding them till maturity. Let's assume an FMP that invests in a couple of one-year CDs trading at 9.5-9.7 per cent. Since it will hold the CDs till maturity, it can be expected to return 8.5-9 per cent to investors after deducting the expenses incurred. Since FMPs are passively-managed, their expense ratio is on the lower side (up to 1 per cent).
"People should not expect super-normal returns. In a good scenario, FMPs will return 1-2 per cent more than debt," says Raghavendra Nath, managing director, Ladderup Wealth Management.
SAFETY FIRST
The tenure of debt securities in which capital-protection funds and FMPs invest cannot be more than these funds' tenure. Because the securities are held till maturity, the risk of a fall in prices during the holding period due to interest rate changes is nil, making these funds less volatile.
Capital-protection funds have maturity period of one, three and five years while FMPs are typically for short investments of 30, 180, 370 and 395 days.
Equity exposure makes capitalprotection funds volatile. However, FMPs are pure debt funds and mostly managed passively. This minimises volatility.
RIGHT TIME TO INVEST
Though the choice of fund will depend on the investment goals, capital-protection funds work best when markets are falling and the investor wants to preserve capital. Another ideal condition for them is the high yield on debt securities. This ensures that the goal of capital protection is met with a smaller investment and more money is available for investing in equity.
Similarly, FMPs are ideal when bond yields are high. Yields on CDs, CPs and corporate bonds of more than one-year maturity are 9-10 per cent. With the Reserve Bank of India likely to cut interest rates this year, the yields will fall. Therefore, it is a good time to invest in FMPs and capital-protection funds.
Yield is the rate of interest earned calculated by dividing the fixed interest paid by the price at which the bond is trading. "In the light of attractive yields in the AAA corporate segment, we believe that this may be a good time for launching such funds," says Puneet Pal of BNP Paribas Mutual Fund.
TAX EDGE
If the investment in debt funds is held for a year or more, capital gains (long-term) are taxed at 10 per cent without indexation and 20 per cent with indexation. Indexation is adjusting the purchase price for inflation. In FDs, the interest earned is included in the income and taxed. Thus, tax treatment and indexation benefit give debt funds an edge over FDs. Short-term capital gains are taxed as per the person's income-tax slab.
In debt mutual funds, the least risky options are capital-protection funds and fixed-maturity plans or FMPs. Both are close-ended schemes where no redemption is allowed before maturity.
THE OBJECTIVES
The main aim of a capital-protection fund is to protect the principal by investing a part of it in fixed-income instruments such as bonds, T-bills and certificates of deposits (CDs). The rest is invested in equities.
"The debt-equity allocation is based on the yield on bonds and the tenure of the scheme," says Puneet Pal, head, fixed income, BNP Paribas Mutual Fund.
Imagine a fund of Rs 100 which invests in debt securities with 10 per cent yield. To protect its capital, it will invest Rs 90.909 in these securities so that this amount becomes Rs 100 (at 10 per cent yield) after a year. The rest, Rs 9.091, will be invested in equity or related instruments.
The value of the equity portion at the end of the tenure will be the gain. If it grows 15 per cent to Rs 10.45, the value of the investment at the end of the tenure will be Rs 110.45, a gain of 10.45 per cent. If the equity portion falls 15 per cent to Rs 7.73, the gain will be 7.73 per cent. "Investors must note that the capital protection offered is not guaranteed but only assured," says Jiju Vidyadharan, director, Funds & Fixed Income Research, Crisil Research.
The Securities and Exchange Board of India has mandated rating of the fund structure by a credit rating agency for assessing the degree of certainty with which the objective of protecting capital can be met.
"The top rating for capital-protection funds is AAA, indicating the highest degree of certainty regarding timely payment of the principal on maturity," says Vidyadharan.
FMPs, on the other hand, generate FD-like returns by investing in bonds and holding them till maturity. Let's assume an FMP that invests in a couple of one-year CDs trading at 9.5-9.7 per cent. Since it will hold the CDs till maturity, it can be expected to return 8.5-9 per cent to investors after deducting the expenses incurred. Since FMPs are passively-managed, their expense ratio is on the lower side (up to 1 per cent).
"People should not expect super-normal returns. In a good scenario, FMPs will return 1-2 per cent more than debt," says Raghavendra Nath, managing director, Ladderup Wealth Management.
SAFETY FIRST
The tenure of debt securities in which capital-protection funds and FMPs invest cannot be more than these funds' tenure. Because the securities are held till maturity, the risk of a fall in prices during the holding period due to interest rate changes is nil, making these funds less volatile.
Capital-protection funds have maturity period of one, three and five years while FMPs are typically for short investments of 30, 180, 370 and 395 days.
Equity exposure makes capitalprotection funds volatile. However, FMPs are pure debt funds and mostly managed passively. This minimises volatility.
RIGHT TIME TO INVEST
Though the choice of fund will depend on the investment goals, capital-protection funds work best when markets are falling and the investor wants to preserve capital. Another ideal condition for them is the high yield on debt securities. This ensures that the goal of capital protection is met with a smaller investment and more money is available for investing in equity.
The tenure of debt securities in which capital-protection funds and FMPs invest cannot be more than these funds' tenure
Yield is the rate of interest earned calculated by dividing the fixed interest paid by the price at which the bond is trading. "In the light of attractive yields in the AAA corporate segment, we believe that this may be a good time for launching such funds," says Puneet Pal of BNP Paribas Mutual Fund.
TAX EDGE
If the investment in debt funds is held for a year or more, capital gains (long-term) are taxed at 10 per cent without indexation and 20 per cent with indexation. Indexation is adjusting the purchase price for inflation. In FDs, the interest earned is included in the income and taxed. Thus, tax treatment and indexation benefit give debt funds an edge over FDs. Short-term capital gains are taxed as per the person's income-tax slab.
