Fixed maturity plans can be termed as the mutual fund industry's answer to Fixed Deposits (FDs). Over the years, FMPs have established themselves as an option for debt fund investors (i.e. risk-averse investors). In many cases, they occupy the slot that used to belong to FDs. This is not surprising given that both the avenues cater to the same investor category.

Having said that, it is worth noting that FMPs and FDs also vary across a few critical parameters. It is important that investors appreciate the dissimilarities between the two avenues so as to make the right investment decision.

At Personalfn, we receive several queries from investors inquiring about which is the better option. This note highlights the difference between FMPs and FDs, and guides investors on selecting the option most suitable to them.

Assured returns vs Indicative returns

The defining feature of both FMPs and FDs is that investors know in advance how much return they will earn on maturity. The difference is, while the returns on FDs are assured, returns on FMPs are indicative. However, many investors confuse FMPs with FDs and believe that the returns offered by FMPs are also assured.

FMPs are actually close-ended debt funds (investments can be made only during the new fund offer period) with a fixed maturity offering an indicative yield (both the maturity and yield is known upfront). Here the keyword is indicative. That means, on maturity, there is a possibility of the actual returns deviating from what has been indicated to investors at the time of investing. On the other hand, returns are guaranteed in an FD and investors are assured of receiving the same on maturity (assuming there is no credit default).

• FMPs: Don't ignore the risk

Varying tax treatment

The tax treatment on interest income is different for FMPs and FDs. In FDs, the interest income is added to the investor's income and is taxable at the applicable tax slab (or the marginal rate of tax).

As far as FMPs are concerned, the tax implication depends upon the investment option -- dividend or growth. In the dividend option, investors have to bear the Dividend Distribution Tax. Whereas in the growth option, returns earned are treated as capital gains (short-term or long-term depending on the investment tenure).

In the case of short-term capital gains (i.e. if investments are held for less than 365 days), the interest income is added to the investor's income and is taxed at the marginal rate of tax.

As for long-term capital gains (if investments are held for more than 365 days), the tax liability is computed using two methods i.e. with indexation (charged at 20 per cent plus surcharge) and without indexation (charged at 10 per cent plus surcharge); the tax liability will be the lower of the two. Thanks to the indexation benefit, FMPs end up delivering more tax efficient returns than FDs. An example will help understand how this works.

Tax Implication on FMPs and FDs

(We have not displayed the 'without indexation' option, as the tax liability in the 'with indexation' option is lower. CII-Cost Inflation Index, NA-Not Applicable)

Take an investor who had invested Rs 100,000 in an FMP and an FD (both having a maturity of 375 days) in the financial year 2006-07. Both, the FMP and FD offered a return of 8.25 per cent and were due to mature in the year 2007-2008. After adjusting for tax, investor earns a return of 7.74 per cent on the FMP; while the post-tax return on the FD is 5.45 per cent (assuming he is in the highest tax bracket). The higher tax-adjusted return on the FMP can be attributed to the indexation benefit.

Investors must note that in the above calculation we have made some assumptions:

1. We have assumed a past scenario for ease of understanding and because of the availability of important information such as the Cost Inflation Index, which is used in the calculation.

2. The interest rate offered by FMPs and FDs in the year 2006-07 would have been different from what we have assumed here. Moreover, for ease of understanding, we have assumed the same interest rate (i.e. 8.25 per cent) for FMPs and FDs. In reality, they may offer different interest rates; in most cases the FMP, being market-linked, can be expected to offer a higher return than an FD.

3. The investor, considered in the example, falls in the highest tax bracket.

In a nutshell�

While FMPs offer superior post-tax returns vis-�-vis FDs, returns offered by them are only indicative and not assured. Given the fact that returns are not assured, FMPs are riskier than FDs.

Having said that, it should be noted that FDs also have their own share of risks. FDs are usually rated; the credit rating of an FD is an indicator of the degree of risk associated with it. For instance, a rating of 'AAA/FAAA' offers the highest level of safety. So, an FD with a credit rating lower than this (as also an unrated FD) carries higher risk.

5 things to look at in an FD

What should investors do?

For investors, looking for a competitive return at minimum risk, both FMPs and FDs are options. To choose between them, investors need to take into account their risk profile and investment objective among other factors. For instance, while FMPs may appeal to investors willing to take a little risk for that extra return; FDs will find favour with investors who are satisfied with a lower but assured return.

Having said that, investors would do well to consult their investment advisors/financial planners to determine what avenue will be most suitable to them.

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