Know your Fixed Maturity Plan

Published in The Hindu - Sunday Magazine on Nov 9, 2008

Debt mutual funds including FMPs (Fixed Maturity Plans) do not always deliver on their indicative returns and may even put your principal at risk.

If the above statistic appears to you like an agricultural nutrient recipe for cultivating high yielding sugarcane, let me assure you that you are not alone. Unfortunately the data has nothing to do with crop cultivation; it represents the investment portfolio of an FMP (Fixed Maturity Plan). FMPs are a popular category of Debt mutual funds that are sold as an alternative to Fixed Deposits (FDs) for their comparative tax advantage. But, I am sure even those of you who regularly invest in FMPs may be getting a glimpse of what constitutes their investments for the first time. The portfolio listed above indicates ‘structured obligations’, otherwise called as ‘asset backed securities’ or ‘securitized loans’.

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% 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’)

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. The offer document for the fund (distributed to prospective customers) discloses ‘indicative returns’ and ‘indicative investments’, but they are just that – ‘indicative’- which in financial parlance means ‘not true’ or ‘trust us with your money but we don’t want to tell you what exactly we are going to do with it’

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). You see…this attitude actually helps the peer group to collectively take-on extra risk. May be this is why the portfolio of many mutual funds actually look alike.

Myth4: 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 to real estate companies 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. You might remember that I had covered this in detail, using the example of CDOs in the article ‘When the Bubble Burst’ (Oct 5, The Hindu, Sunday Magazine). 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 pan-wala at 35% annual interest rate to be repaid over 2 years s
Step 2: Finance company has issued 500 crores of such loans and needs more money so that it can issue more of these lucrative loans
Step 3: Finance company Treasury Head calls Debt fund manager and enquires – “are you interested in making 20%-25% p.a return on your investment by buying personal loans from us?”
Step 4: Debt Fund Manager: “of course I am interested - are you kidding me, I can barely get 8% 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. Also, a couple of my colleagues managing other Debt funds may be interested.”
Step 5: Treasury Head: Great! What I will do is 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. You and your friends can pay me 1150 crores upfront (15% profit on 1000 crores) and buy the SPV. I will keep crediting the EMIs collected every month from customers of these loans, into the SPV, and you can withdraw at your convenience. Although I am charging a 15% markup 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%.
Step 6: Debt Fund Manager: Okay. But what if the customers default in paying EMI’s? Will you compensate me?
Step 7: Treasury Head: We have paid lots of money to a leading credit rating agency to evaluate our loans. They have said that only 5% of these loans will experience customer default, so what I will do is compensate you for loss up to 5%. 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. My friends and I will pay you 1150 crores upfront and buy the assorted loan package (otherwise called ‘structured obligations’) between the three Debt funds that we manage.
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? What if my Debt mutual fund/ FMP invests in packaged loans, as long as I get my high returns? 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. Similar pattern has been observed in other segments such as credit card 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 2%) 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.

You too can check if your fund has invested in ‘structured obligations’ by logging on to http://www.valueresearchonline.com/ and clicking the portfolio details of your fund. You can also find out the % of money allocated to these instruments, by your fund.