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In the fixed income mutual fund space, the assets under the passive options is increasing rapidly. As of Oct’22, its stands at over INR 1500 bn. As the interest in the space increases, there are more innovative solutions introduced. One such solution is being discussed here.
What are the investment “passive” options available in the fixed income mutual fund space?
In the fixed income mutual fund space, the following passive options are available:
- Roll down funds (open ended)
- Target date maturity Index Funds
- Fixed rate maturity plans
- Fixed rate maturity plans investing in STRIPS
What is a STRIPS?
- STRIPS is an acronym for Separate Trading of Registered Interest & Principal of Securities.
- Government Security pays coupon on semi-annual basis and principal is paid back at maturity. Each of the payouts is converted (stripped) into individual instruments. For e.g.: A 3 year G-Sec would have 6 semi-annual coupons and one principal payout at maturity. From this, 6 instruments are created where in 5 are from coupon payments and one if of last coupon payment and principal. All of these are zero coupon bonds.
What is an FMP investing in STRIPS?
The Fixed Maturity Plan (FMP) invests in securities that have maturity closer to the maturity of the scheme itself. The underlying investment is STRIPS.
What are the benefits of FMP using STRIPS?
- Re-investment risk is eliminated. This is because there are no intermittent cash flows (from coupons) that need to be re-invested
- Credit Risk is eliminated. The underlying is a pay out from Government of India
- Slippage is minimized. The maturity period of the fund and that of the underlying instrument are close and hence there is minimal slippage from the fund holding cash
How are the features different?
Should investor lock-in in FMPs?
- We have analysed the live performance of three large roll down strategies. The slippage from expectation is to the tune of ~30-50bps on annual basis.
- If Asset Allocation allows for locking in capital, FMPs can be a good option
What would be the taxation?
The long term capital gains (LTCG) with Indexation is applicable like any non-equity oriented mutual fund with a holding period greater than 3 years
What is the expectation of returns?
What are the risks associated to FMPs investing in STRIPS?
There is Liquidity risk. Since it is a listed instrument, secondary sale is possible. However, the depth of the market is limited (as the new buyer would have to hold for 3 years to get LTCG benefit)