Are FMPs risky?

Its been the hottest selling fund category of 2008. FMP AuMs are now well over Rs. 100,000 crores and growing rapidly. In recent times however, some questions have been raised about the risk associated with FMPs. What started off as stray concerns has rapidly escalated with a number of articles appearing in the media about FMP risks – prompting anxious clients to call advisors and find out whether they should be worried about this “safe” investment that they had made.

The key concern

Until recently, lending to NBFCs, brokerage firms and real estate companies looked like smart bets on the back of a booming stock market and a vibrant real estate market. As these underlying markets turned, at least some of the small / fringe players in these segments started to feel the heat – and some of that heat is now being felt in portfolios of FMPs that lent aggressively to these players.

To get a perspective on the risks associated with FMPs, Wealth Forum conducted a panel discussion where two distinguished CIOs interacted with members of the Wealth Forum Advisors Club – which comprises leading independent financial advisors from across India. 

We bring you key takeaways from the panel discussion to help you address your and your clients’ concerns on this critical issue.

(1) Duration mismatch : does happen typically in the short term (1-3 month) FMPs. There is occasional sales pressure for rates to compete with deposits – sometimes leading to mismatches, where longer term paper is taken up in short duration FMPs to boost yield – on FMP maturity, these papers are parked in subsequent FMPs / other schemes. Not a desirable situation – but can be managed by the larger fund houses who have substantial AuMs in debt schemes. Fund managers are pushing back on aggressive “rate wars” at the short end. 

Takeaway : Duration mismatches can be a risk for the smaller fund houses / fund houses that have a small AuM in debt and liquid schemes. If rates offered are higher than market, best to do your homework as advisors and ask questions on duration mismatches, before recommending to clients based solely on indicative yields. 

(2) Credit downgrades : Its important to distinguish between a downgrade and a default. In a downgrade, the market price of the bond will go down and will impact NAV when the portfolio is marked-to-market. This will impact all open-ended funds. However, in an FMP which is typically held to maturity, a downgrade need not mean a loss for the investor, if the principal is paid back on time by the downgraded entity. Its only when there is a default that the FMP suffers a loss – which will impact its investors.

panic on a downgrade, but one should definitely keep tabs on the portfolio quality on a periodic basis – especially in the longer term FMPs. Advisors need to do independent homework on accessing ratings downgrade information and seeking full portfolio disclosures of longer term FMPs – especially those that offered higher-than-market indicative yields.

(3) Roll-overs : A corporate which is unable to repay principal on maturity seeks a roll-over of the paper : effectively seeks more time to pay up. Neither of the fund managers on this panel have encouraged these kind of default-related roll overs. Only roll overs in the normal course of business – where you anyway lend to sound institutions based on your credit appraisal - are executed by these fund houses. 

Takeaway : Roll-overs (other than business-as-usual ones) could spell trouble – as the fund manager may be effectively postponing recognising the problem in the hope that the company will pay up in the extended time-frame given. There are no easy ways of determining roll-overs when you look at the portfolio – the only solution is to maintain a dialogue with the fund house in cases where you see portfolios with holdings that have got downgraded.

(4) Defaults : If an FMP portfolio is made up of AAA/P1+ instruments, history suggests that the probability of a AAA rated company turning a defaulter over a 12-18 month period is less than 1%. The biggest area of concern is FMPs that have taken an exposure to second rung real estate companies in a bid to boost yields – many of these companies are overleveraged and may find it difficult to go through a prolonged downturn in real estate markets. Both fund managers in this panel are comfortable with their own real estate exposure – but acknowledge that this is one area which needs to be very carefully tracked. One cannot rule out problems down the road in this sector. Another segment that needs to be tracked closely is companies that had mega IPO plans – which have now got derailed due to poor market conditions : some of them have made commitments based on assumptions of cash flow from their IPOs – and may struggle as a result.

Takeaway : Advisors need to look closely at the ratings profile and quality of the FMPs they’ve previously sold as well as the ones they are currently selling. Identify which of the FMPs you’ve sold previously are the ones you need to monitor closely and commit yourself to taking out the time to do so periodically. 

If we are indeed likely to see some slowdown in economic activity as some analysts suggest, these are clearly not times when one should be aspiring for aggressive yields – rather, these are times when one should focus on safety first.

Conclusion
The old saying “don’t throw the baby out along with the bath water” seems apt for FMPs. It’s easy to get carried away either way – to sell aggressively in good times without doing your homework or completely shun this asset category due to credit quality concerns in some FMPs. A sensible approach is to recognise that the category continues to have all the merits of tax efficiency, reasonable predictability of returns and low risk – provided you stick to selling FMPs that do not compromise on portfolio quality in the quest of superior returns.

Source: http://www.wealthforumezine.net/paneldiscussion.html?mEmail=&mVolume=20081001