How Mutual Funds Remove Reinvestment Risk from FMPs

These FMPs invest in STRIPS for G-Sec, not G-Sec itself. Let’s see what these STRIPS are.

reinvestment risk

Interest rate risk, credit risk and liquidity risk are usually of interest to investors when it comes to investing in fixed income, but there is one risk that is rarely talked about. That’s reinvestment risk.

What is this? When you invest in a bond, you also receive coupon payments, usually semi-annually (twice a year), apart from the principal payment at the end of the bond’s maturity.

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Investors may or may not be able to reinvest these coupon payments at the same yields offered by the original bonds as yields may fluctuate depending on market dynamics.

How are STRIPS created?

STRIPS stands for Registered Interest and Principal Securities Separate Trading. This is the process of splitting a bond into multiple securities, each representing a cash flow to be paid when it is due.

for example, ¥6% G-Sec 2026 of 100 is broken down and payment for each coupon ¥3 (paid semi-annually), coupon STRIP and principal payment ¥100 (pay at maturity) becomes the principal STRIP (see diagram).

These cash flows are split into individual securities and traded as STRIPS on the secondary market. STRIP maturity coincides with coupon or principal payment due date. For example, if the first coupon expires in his 6 months, that particular his STRIP will also expire in his 6 months.

These STRIPS are essentially Zero Coupon Bonds (ZCB). These securities have no coupon payments, thus eliminating the risk of reinvesting at a lower yield. Bonds are converted into his STRIPS by the primary dealer, who charges 2-4 bps to create his STRIPS. Currently this process is only allowed for G-Secs.

Who Should Go to FMP STRIPS?

FMP is a closed end fund. Investors participating in the FMP should therefore wait until the fund matures. If yields or interest rates decline, reinvestment risk could shave 20-30 basis points (bps) off the originally stated return.

For investors who are unsure of their ability to continue investing beyond the fund’s maturity, Target Maturity Funds (TMFs) may be an alternative. Investors must trade reinvestment risk to access TMF liquidity.

Since the TMF is unlimited, you have the option to withdraw before the fund’s maturity. Although TMFs allow early withdrawals, investors may not get returns close to the index yield on such exits.

Only choose STRIPS FMPs if you have a clear investment horizon and can withhold funds for the entire duration of the FMP.

BondsIndia co-founder Ankit Gupta offers additional tips. “Check your level of investment in STRIPS and your outlook for interest rates. Could interest rates fall from their current levels? Then STRIPS makes sense.”

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