If you are investing for retirement, you need passive income to cover your expenses. But safe and consistent income is hard to come by nowadays. The ugly truth about retirement is that the traditional way of generating income doesn’t work anymore due to the modern loose monetary policies.
While the low-interest rate is great to reduce mortgage repayments for property investors, it is disastrous for income seekers. To be debt-free is now a liability because the value of your asset grows slower than inflation.
If you put your money in the banks, you are earning nothing. If you invest, you subject yourself to the stock market uncertainties. Not to mention that we are still in a volatile environment with the pandemic, deglobalization and looming recession.
Singaporeans like to invest in so-called blue-chip high dividend stocks. But look at the popular picks in the past five years:
- Singtel’s share price dropped from $3.86 to $2.12, a 45% loss.
- Singapore Post dropped from $1.8 to $0.69, a 62% loss.
- SPH dropped from $3.77 to $1, a 73% loss!
Are the dividends enough to compensate for the capital loss that you suffered? We are not even talking about companies like SIA whose planes are grounded due to the pandemic or the associated SATS business, these are the names that many Singapore income investors were keen to use for “long term investment” and “dividend play”.
In the course of my work as a financial adviser, I can see that most people are limiting their choices of income instruments to only a few:
But in today’s environment, you need to look beyond traditional investment products. In this article, I will introduce you an income instrument that is trending in recent years which you may not be familiar with, Fixed Maturity Plan (FMP).
There are many other options out there, remember to subscribe below for future discussions.
What is a Fixed Maturity Plan (FMP)
When you invest for income, you want to achieve two objectives at the same time:
- A consistent income with an attractive yield
- Certain capital preservation
Fixed Maturity Plan (FMP) does just that. FMP, also know as Fixed Maturity Portfolio or Fixed Maturity Fund (FMF), is not a new investment product. But it becomes popular around 2016 given their ability to pay out regular income and attractive yields. I will mainly talk about Fixed Maturity Bond Fund today as it is the most common FMP.
If you rank the risk and reward, Fixed Maturity Bond Funds are somewhere between short term endowment plans and bonds or bond funds. A Fixed Maturity Bond Fund is typically a globally diversified bond portfolio with a fixed maturity date. The “duration” of the underlying bond typically matches the maximum maturity date.
FMF does not have the explicit guaranteed provided by the insurance company and there is no capital guarantee, which is why they can offer a higher yield. But at the same time, it reduces the traditional risks of investing in bonds or bond funds.
Why Fixed Maturity Plans are better than traditional bonds and bond funds
If you invest in a single bond, your biggest risk is the default risk. This pandemic this year has reminded us that your familiar names can fall too. We already saw Hertz and JC Penny to go under at a blink of eyes. Even before the pandemic, the bond default by Swiber as well as the Hyflux saga should still be fresh in your mind.
If you invest in bond funds or bond ETFs, you can eliminate most of the default risk as the managers have done the necessary due diligence for you. Even if one underlying bond defaults, the whole portfolio may only be slightly scratched given the benefit of diversification. But traditional bond funds face two challenges:
I. Open-ended structure
Traditional bond funds are “open-ended” funds, This means that you can buy and sell them anytime. Therefore, the fund manager needs to leave a “buffer” to cater to the cash flows which will affect the performance.
- If more money goes into the fund, the fund manager may not be able to find opportunities to deploy the cash;
- If a crisis hits (like in March this year), investors will withdraw a large amount of investment and force the manager to sell the underlying bonds at an unfavorable price.
This explains why many skillful fund managers are not able to deliver up to expectations in some period.
II. No maturity date
Because there is no maturity for bond funds and bond ETFs, the manager has to keep on reinvesting the proceeds whenever an underlying bond matures. Because we are in a prolonged declining interest rate environment, every time the fund manager reinvests, he gets a worse coupon. Consequently, the new bond will dilute the performance of the entire portfolio.
Fixed Maturity Plan has the best of both worlds.
- The default risk of the underlying bonds is extremely low due to diversification.
- The tenure of the underlying bonds and the tenure of the fund are aligned.
- The fund manager can and normally will hold all the underlying bonds until maturity and get back the original capital.
- The fund manager does not need to keep cash or worry that investors redeem the funds unexpectedly.
- Investors are “forced” to invest in the long term which reduces irrational behavioral risks.
The table below is a summary of the benefits among the Fixed Maturity Plan, direct bond, and bond funds.
Is a Fixed Maturity Plan safe?
As explained earlier, the key advantage of this type of fund is that it provides you with a payout structure that is comparable to a single-bond investment, but with greatly reduced single-issuer risk due to diversification.
If you think about it, a short term endowment insurance plan has a similar structure as a fixed maturity product. The insurer “borrows” the money from you and invests in the underlying fixed-income instrument. They pay you back your capital at maturity together with the income, after deducting their fees.
The only difference is that the insurer doesn’t show you what are the underlying bonds and you have no idea if the price of the underlying bonds drops. So in a way, they prevent you from doing “stupid” things by being not so transparent with you.
Although a Fixed Maturity Plan’s value uses a mark-to-market (MTM) valuation, it is unlikely that you will sell the fund prematurely due to its “lock-in” feature. If you really need the cash, you can sell a Fixed Maturity Plan before maturity by paying a small penalty.
So if you can find a competent manager and align your cash flow needs with the maturity of the fund, then a Fixed Maturity Plan is a low-risk instrument that you can leverage for a better yield.
A Fixed Maturity Portfolio example
Similar to short term endowment plans, FMP is typically on a limited tranche too. When the fund manager identifies an opportunity, they will typically do an IPO, gathers all the investors and kick starts the investment on a common day (so they can all mature on the same day).
The latest product in town is Aberdeen Standard Investment’s New Fixed Maturity Product Oct 2020. The portfolio is formed by around 100 Emerging Market bonds with a net distribution yield of 3.3% to 3.4%.
The fund will mature in 4 years and you can choose a USD or an SGD-hedged fund. You will receive a quarterly dividend payment. The value of the fund will fluctuate over the years due to “mark-to-market”, but you are expected to receive your initial investment at the maturity date if there is no default of the underlying bonds.
To see how this works in real life, you can refer to Aberdeen Standard Emerging Market Bond Fixed Maturity 2023, a similar product launched in Oct 2019. As you can see from the chart below, despite the Mark-to-Market drawdown in value in March, the fund has quickly climbed back to the previous level once the market normalized.
Are emerging market bonds safe?
You may hear the phrase “emerging market bonds”, but you probably don’t know much about it. The word “emerging market” is really a western term referring to other developing countries (from their perspective). For us in Asia, the emerging market is next to our door.
When it comes to investing, people tend to fall into familiarity bias. People are more comfortable with US High Yield bonds just because of the perceived safety, but the fact is that emerging market high yield bonds have had a lower default rate compared to their US counterparts in the past decade. This is clearly shown in the chart below.
You may realize that due to this perceived risk, investors demand a higher yield from emerging market bonds, which allows us to still get a decent yield in the zero interest rate environment.
Additional Reading: High Yield Bond: Why You Need It in Your Retirement Investment Portfolio
Let me summarize
Fixed Maturity Plan can offer you a yield pickup by investing in a globally diversified portfolio of bonds with a maximum maturity close to the fund’s expiration date. You receive a quarterly dividend payout and get back your capital when the fund matures.
If you are tired of rolling your fixed deposits every month, not satisfied with the low return offered by the insurance savings plans, yet you do not wish to invest in stocks, you need to move beyond traditional assets and move to alternative investments and Fixed Maturity Plan is an option. Comment below if you have any questions about FMP.
Update (Oct 26, 2020) – The subscription of the tranche of Aberdeen’s Fixed Maturity 2024 is closed. If you want to be updated for other investment opportunities in the future, subscribe to the mailing list using the form below.