The glitches in the payouts of fixed maturity plans or FMPs from two of India’s most respected fund housesKotak Mahindra AMC and HDFC AMC – indicates that the debt crisis is starting to affect retail investors. This was inevitable and fixed maturity plans were always among the instruments most vulnerable to defaults.

By the Reserve Bank of India’s estimates (which have been consistently on the optimistic side), the banking system had around 10.8% of advances embedded in gross non-performing assets (unpaid loans) by September 2018, and, assuming things proceeded more or less as the RBI expected (its “baseline scenario”) gross non-performing assets would probably drop to 10.3% by March 2019.

It is too early to say if that estimate holds since most public-sector banks have not yet declared results. But that amounts to about 7.5% of gross domestic product since banking credit is about 75% of India’s gross domestic product.

There are also vast amounts of debt held outside the banking system in the form of corporate bonds, corporate paper and corporate deposits. Bonds are secured instruments in the sense that a bond holder could go to court and ask for the company’s liquidation if the terms of repayment are not met.

But commercial paper, a short-term debt instrument issued by a corporation, and certificate of deposit, a savings certificate with a fixed maturity date and rate of interest, are unsecured – it is entirely up to the company to service these. Lenders subscribe to all these on the basis of the company’s credit rating and its reputation. The better the credit rating and reputation, the less the interest lenders demand.

Mutual funds hold a large proportion of these instruments, secured and unsecured. As of March 2019, mutual funds held around Rs 12.5 lakh crore worth of various categories of debt – this includes large chunks of government debt, which is not at risk.

One problem with the debt crisis is that it has affected even corporate groups with decades of experience, and long-standing records of profitability. In several instances, the credit ratings of the affected borrowers has been excellent until the point where defaults have actually started. The debt crisis has also hit corporates across multiple sectors, making it even harder for lenders to be selective about what they subscribe to. So the debt crisis has made those criteria – credit ratings and reputation unreliable.

FMPs and tax saving

Fixed maturity plans are a play on tax. These tend to attract the same breed of investors who like fixed deposits. Fixed maturity plans invest in corporate debt. A fixed maturity plan is a closed fund that raises its corpus within a narrow time window and closes out, returning the money and the interest accrued, on a specific date. So it looks a lot like a bank fixed deposit. Since the fund knows the exact date of closure, it can invest in instruments, which will mature around the same time and hence, it can offer an indicative return, usually with a very high degree of accuracy.

The tax efficiency arises from the fact that fixed maturity plans can last exactly long enough to cut tax to a minimum. The interest on a normal fixed deposit is added to normal income and taxed at the rate applicable. For most investors, who tend to be in high tax bracket, this works out to the highest tax rate – that is approximately 33% of the return with the surcharge thrown in. Any debt fund that is held for over three years is liable only to long-term capital gains. That is 20% tax after indexation to inflation. That is a huge advantage.

To give an indication, assume a fixed deposit gives 6% per annum and a fixed maturity plan offers the same. Over a three year period, the fixed deposit holder pays roughly 2% tax per annum. Now, assume that the indexation rate is set at 4% for this period (the Income Tax Department releases the indexation rate every year). The fixed maturity plan holder will pay the equivalent of roughly 0.4% tax per annum post-indexation.

Fixed maturity plans further maximise the tax advantage by raising money in the last months of the financial year (February and March) and closing out early in the financial year (April). This means the tax benefit is available for a fixed maturity plan after just 37 months. In addition, fixed maturity plans offer higher indicative rates than fixed deposits.

Malaise in debt market

Where is the downside? In order to generate a higher return, fixed maturity plans invest in unsecured corporate debt. While the principal in a bank fixed deposit is guaranteed until the Rs 1,00,000 level and there has never been a failure to pay in practice, fixed maturity plans are not guaranteed.

The problems with the affected Kotak and HDFC mutual fund schemes seem to be relatively minor at first glance. Those six schemes have exposure to the Essel-Zee Group which has been in trouble for months. Kotak is closing out the schemes without the return from the Zee Group component, stating that it will return that portion once it gets paid by Zee Group (perhaps around September 2019). HDFC Mutual Fund wants to roll over for an extra year.

The first issue is behavioural. Fixed maturity plan investors are just as risk-averse as fixed deposit investors and it is a shock for them to discover that their cash is not safe. Also fixed maturity plans are often taken by people who have mentally reallocated those funds to some other purpose, at the time of closure, and who are now short of liquidity on some other front, where they were intending to use those funds. This could be prepayment of a housing loan, a family wedding, or whatever. Not getting the full indicative return at the specific time is hard for these investors to take.

The reason for this crunch indicates the deeper malaise affecting the Indian debt market. Unlisted firms in the Zee group borrowed money, pledging shares in listed group companies as collateral. When the defaults happened, and some creditors sold the pledged shares, the share price crashed. So creditors could not recover the full value of their outstanding loans.

The group asked for time and came to a “standstill” arrangement. Creditors would give the group time until September to arrange to repay loans (probably by selling strategic stakes in businesses, or by selling assets). Until September, creditors agreed that they would not sell the pledged shares. If they are lucky they will recover their loans.

In this particular instance, as in many others, credit ratings and reputations turned out to be misleading. Taking pledged shares as collateral is also a dangerous procedure because the value of those shares drops the instant the default situation is known.

Dodgy debt?

Most mutual fund investors are aware that funds carry some risk. Equity funds are obviously exposed to swings in share prices. Most debt funds also carry varying levels of risk to principal because debt funds trade debt to try and profit from swings in interest rates. Fixed maturity plan investors are now learning to their dismay that even these fixed deposit-liked instruments carry risk.

This may be just the tip of the iceberg where a lot of mutual fund debt is concerned. Pledging shares to raise loans is an accepted Indian custom and the credit rating system appears to be completely broken. Given the mayhem in banking and non banking financial companies, it is extremely probable that a lot of debt held by funds is dodgy, to say the least.