When the stock market pendulum sways with greater amplitude, small investors clamour for risk-free, fixed-return instruments and the first thing that comes to one’s mind is bank fixed deposits. But bank fixed deposits (FD), like the income funds of mutual fund houses, are not free from risks either.

Consider this: A year ago, the interest rate on a one-year bank fixed deposit was between 5.5 and 6 per cent. Now, banks have raised their deposit rates and the one-year rate hovers between 6 per cent and 6.5 per cent. If you had parked your funds in a bank fixed deposit even a year ago, you stand to earn less on your investment than what you would have earned had you invested it now.

However, the fixed maturity plans (FMP) of mutual funds take care of this interest rate fluctuation and yet give an indicative rate of return. They are tax effective too.

What’s that?

Fixed maturity plans of mutual funds have a fixed life span, just like a bank fixed deposit. But the difference between the two is that while fixed deposits give an assured rate of return, fixed maturity plans don’t. The funds of FMPs are invested in fixed income assets, such as bonds, government papers, corporate bonds and money market instruments, which have the same maturity as the FMP.

For example, a three-year FMP will invest only in three-year bonds. As the bonds will be due for redemption on the day the FMP’s tenure ends, the redemption value of the bond will be equal to its market price. So, investments in FMPs can be made according to the future cash flow needs. These are generally closed-end funds, but some houses offer open-ended FMPs as well.

The FMP edge

This investment philosophy is not followed in other income plans of mutual funds. Hence, while income funds are more susceptible to interest rate risks, FMPs are not. When the overall interest rates rise, the prices of fixed income instruments fall and vice versa.

It has also been noticed that FMPs of more than one year give better returns than bank FDs of same maturity. Returns in shorter-term FMPs, however, lag behind their FD counterparts.

However, the greatest advantage of FMPs is their tax efficiency. On redemption after holding for at least a year, FMP investors can use the benefit of indexation for capital gains that has been denied to bank fixed deposits and bonds. A tax of 10 per cent on long-term capital gains works out economically better than the personal income tax rate.

Besides, the dividend from an FMP is tax free in the hands of the investor.

The caveat

The basic structure of an FMP does not lend itself to liquidity. Redemptions before maturity attract an exit load to the extent of 3 to 4 per cent. So, choose the plan tenure accordingly. The maturities of FMPs are declared when the funds are opened for subscription.

Hence, invest an amount which you won’t need before the maturity of the plan. Redemptions before one year will attract short-term capital gains tax and be added to the investor’s income to be taxed at the applicable slab rate.

An FMP being basically an income scheme of a mutual fund, the tax incidence would be similar to that on traditional income schemes.