When stock markets tumble and investors scamper for a safer haven, fund managers come up with new schemes for capital protection and higher return. This year mutual funds launched equity-linked fixed maturity plans (FMPs).

Though equity-linked FMPs look attractive in the backdrop of the current market situation, investors should stay away from these “structured” products.

Equity-linked FMPs invest primarily in equity-linked debentures (ELDs) and securitised debt instruments. These have a very complex structure. Besides, the number of issuers of ELDs and securitised debt instruments is also quite limited in the country.

Limited players

Only seven to eight non-banking financial companies, most of which are subsidiaries of foreign banks and financial institutions, such as Citibank, Merrill Lynch, Deutsche Bank and Kotak among others, issue ELDs in the country.

There were just three issuers when ICICI Prudential Mutual Fund first came up with an equity-linked FMP in February this year.

Since then, the number of equity-linked debenture issuers has grown three-fold and ICICI Pru itself has come up for a second serving with the ongoing SMART Fund.

The number of issuers and the market for securitised debt was limited so far. Housing and auto loans were the ones to be securitised.

Only a few private sector banks, having a large portfolio of home and auto loans, had ventured into securitised debt instruments to clean up their books and free capital.

Securitisation of personal loan and credit card dues has not yet taken off. But this may become a reality soon if the demand for securitised debt increases from mutual funds.

These highly sophisticated and complex products led to the recent financial crisis in the US spilling over to the rest of the globe.

Most of the current issuers of such structured products in India have international origin, and, despite stricter accounting, disclosure and credit rating norms in the US and other developed markets, the parent banks suffered huge losses.

In the same boat

After the successful launch of an equity-linked FMP by ICICI Prudential — the close-ended scheme collected a hefty Rs 300-crore-plus — DSP Merrill Lynch, Deutsche Mutual Fund, Birla Sun Life, UTI, Tata and HSBC joined the queue.

The eagerness of fund houses to launch equity-linked FMPs spruced up the demand for ELDs. However, the presence of a limited number of issuers may lead to the concentration of funds in a few hands.

Any default or crisis on the part of any one of the issuers will spell doom for investors in equity-linked FMPs.

In these instruments, the credit risk lies primarily with the issuer of ELDs — default on the part of the issuer will mean that investors will lose their capital investment.

Then, why this rush to launch equity-liked FMPs? The reason is that in the first six months of 2008, regular fixed maturity plans have mobilised Rs 64,000 crore and another 130 schemes have not disclosed their initial collections.

Given the average mobilisation of Rs 250-300 crore per FMP this year, the total investment in fixed maturity plans so far has been more than Rs 1,00,000 crore.

This is a little less than 20 per cent of the total asset under management of all mutual fund houses.

Complex structure

Equity-linked FMPs are structurally different from ordinary fixed maturity plans. While a regular FMP invests in debt papers having the same maturity as the tenure of the plan itself, an equity-linked FMP invests between 80 per cent and 95 per cent in ELDs and the rest in securitised debt and money market instruments to meet the interim redemption pressure.

ELDs are “structured” products comprising zero coupon bonds and index or equity futures. These non-convertible debentures do not bear any interest rate. Instead they give a return linked to the return of the underlying equity or the index.

The fund house gives a large chunk of the fund mobilised under the equity-linked FMP to the issuers of ELDs. Each issuer constructs the ELD on the basis of an agreed participation ratio.

The participation ratio determines the return the ELD will yield as and when the stock markets go up. In case the market slips, the initial capital investment is returned (see illustration). This is ensured by the investment in zero coupon bonds.

Zero coupon bonds are deep discount bonds in which an investor gets the face value of the bond on maturity but no interim interest payouts.

The purchase price of such a bond comes at a discount to its face value. For example, a three-year zero coupon bond having a face value of Rs 100 may be selling at Rs 70 now. That is, if one buys this bond for Rs 70 now, one will get Rs 100 after three years.

Junk bonds

Zero coupon bonds with much higher yields compared with government securities are also known as “junk” bonds. Junk bonds have low credit rating and investment in such bonds is highly risky because the chances of failure on the part of the issuers of such bonds are high. The market of junk bonds is quite big in the US and other developed countries.

When the demand for ELDs grows, issuers are likely to increasingly resort to junk bonds. The investment disclosures of ELDs are not very transparent and, being highly illiquid, the valuation of ELDs is also not done in a transparent manner.

Interestingly, the same fund houses had launched “capital protection-oriented” schemes last year. These schemes were structurally more transparent and less risky than equity-linked FMPs. But, the fund houses no longer offer these schemes.

Stay simple

There are other simple ways to form an investment portfolio to reduce downside risk and capital erosion.

For example, a 3-to 5-year bank fixed deposit fetches a 9.75 per cent interest per annum. If one has an investment kitty of, say, Rs 1,00,000, one can put Rs 74,900 in a three-year bank fixed deposit. This will ensure that on maturity of the fixed deposit after three years, one will get back Rs 1,00,000.

One can invest the remaining Rs 25,100 (Rs 1,00,000-Rs 74,900) in equities or diversified equity schemes of mutual funds or simply in index funds to participate in the share price movements over a period of three years. If the market is down 20 per cent, one will get Rs 1,20,080 (= Rs 1,00,000 + Rs 20,080) after three years. If market goes up by 20 per cent, one will get Rs 1,30,120. If the market remains flat, one will get Rs 1,25,100.

So, measure your moves wisely instead of falling prey to unreasonable temptations.