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B. Venkatesh

A NEWS report states that fixed maturity plans (FMPs) are popular among NRIs. What are FMPs? An FMP invests in bonds that match the maturity of the fund. An FMP with, say, a 10-year horizon will invest in only 10-year bonds. But why an FMP?

Suppose you want to invest now so that you receive Rs 5 lakh five years hence. You will need Rs 3.90 lakh now, assuming that this money grows at a compounded rate of 5 per cent.

You buy units in a regular bond fund. Unfortunately, the interest rate rises just before you redeem the units. Bond prices decline when interest rates increase. The consequent decline in NAV means that you may not receive the Rs 5 lakh you wanted.

The risk of bond prices declining in value because of a rise in interest rates is called interest-rate risk. The FMP controls this risk. How?

Suppose an FMP holds a 4 per cent bond that will be redeemed at Rs 100 in December 2005. Assume a similar maturity bond pays 5 per cent. Investors will obviously not buy the 4 per cent bond unless it is sold at a discount.

Assume the 4 per cent bond sells for Rs 99 till redemption. You will again fail to achieve your investment objective. Fortunately, this will not happen because of the pull-to-par phenomenon.

The market knows that this bond will be redeemed at Rs 100. The bond price would, hence, be "pulled" to Rs 100 by the time it approaches redemption. Else, you can buy the bond at a lower price, redeem at Rs 100 and pocket the gains.

The pull-to-par phenomenon ensures that your investment objective is not defeated because of interest rate changes, especially during redemption.

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