When my uncle called me in the morning and asked me a simple question, it set me thinking, talking, smsing “Is the increasing yield in FMP coming from increased risk” i.e. is the quality of assets falling. And this small note was born.
The retail investor, tired of falling equity markets was (is?) looking for investing some of his money. So here was a customer, interest rates were (are?) hardening, and the mutual funds are running a AUM race.
This deadly combination has led to a multitude of FMP launches.
FMPs, provide protection against rising rates to investors who hold till maturity. In addition, the projected returns are lucrative: indicative yields for several FMPs today are among the best available for fixed income instruments of comparable tenors.
Some FMPs may have begun to move their investments down the credit spectrum in search of these high returns. Investors in FMPs today need to monitor credit risk more carefully than ever before, as any defaults in the underlying portfolio will eat into their returns. Also remember that the fund has an expensive exit clause.
FMPs are investment schemes floated as close-ended mutual funds, and have maturity periods ranging from a month to five years. The popular maturities are normally 91 days and the 367 days maturity. Maturities greater than 3 years are rare, but they do exist. The key to their popularity lies in their ability to generate steady returns over a fixed maturity period, isolating investors against market fluctuations. FMPs are passively managed: the fund manager locks into investments with maturities corresponding to the plan’s maturity, and normally does not disturb the portfolio thereafter. Thus even though you will see a day to day fluctuation in the NAV, the investor will not run too much of a capital (principal) risk.
Thus an investor who does not redeem before maturity is largely insulated from price risk, defined as the potential to make losses on bonds when interest rates rise. FMPs generally also offer higher tax-adjusted returns than fixed deposits (FDs) do.
Unlike returns from bank FDs and risk-free investments, FMP yields are indicative and not assured. Therefore, before investing in these instruments, investors need to understand how FMPs achieve higher yields than FDs.
One of the ways in which FMPs have increased their indicative yields is by investing in credits that are not in the highest safety category. This is a departure from the earlier practice of funds investing largely in the highest (AAA rated) debt issuances, and thus presents a risk that FMPs face relating to the credit quality of their portfolios. One has to keep in mind that in a market with some uncertainties rating can fall quite fast. If you have been there long enough in the markets you might remember Lloyds Finance – the rating slipped from AAA to D in 6 months time. More cruel reminder is the gilt default of Russia – taking LTCM along.
YOU HAVE TO MONITOR CREDIT RISK. NOW: Credit risk monitoring is a key imperative for investors in FMPs. Good risk evaluation reports are available and clients should rely on them before they invest their hard earned money. In order to get a better yield if investors are happy to look at lower graded FMPs, that is good news – for increasing the depth of the bond markets. However, it seems that investors are investing almost blindly when it comes to FMPs and even senior sales people do not understand the risk in FMPs.
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