With maturity period of more than three years, target maturity plans allow investors to benefit from 20% tax after indexation making these ideal for those in the higher tax brackets
Of late, many investors have shifted a sizable part of their investment towards debt mutual funds because the returns and tax-efficient gains are better compared to bank fixed deposits. Due to the default in certain debt schemes from popular fund houses there was apprehension among investors for some time. In spite of that, one category of debt mutual funds that is gaining popularity is target maturity funds (TMFs). Let us discuss the same in detail.
What is TMFs?
Target maturity funds are a type of debt funds that have a specific maturity date, aligned with the expiry date of the bonds that it has in its portfolio. Generally, such funds carry lower interest rate risk and provide more predictive and stable returns. As such, these funds have no default risk since the investment is in government securities and highly rated bonds of public sector companies. For instance, a fund named as ABC Gilt 2027 Index Fund means that investments will be made in government securities and treasury bills with a maturity of April 2027 (Sovereign guarantee).
No interest rate risk
The major advantage of investing in TMFs is that investors can avoid interest rate risk provided they hold on to these until maturity. For instance, when interest rate rises in the future, the net asset values (NAVs) of most of the open-ended debt funds will be affected. But, TMFs have a fixed tenure and investors who hold on till maturity are not affected by the mark-to-market impact on the portfolio of rising interest rates.
As of now, fund houses offer TMFs with a maturity period of five or six years. The yield curve is steep at this maturity period, which sends a signal that such bonds are offering better returns currently. Further, these funds are also tax friendly. As the holding period is more than three years, investors can avail 20% tax rate after indexation. Thus, those who are in the higher tax brackets can get better post-tax returns that they would get in fixed deposits wherein investors are taxed as per the slab rates.
Superior to fixed maturity plans
Majority of the fixed maturity plans (FMP) have a tenure of maximum three years whereas in TMFs, longer tenure options are available. Further, an FMP is structurally a closed-end fund. So, once a new fund offer is closed, investors cannot invest. If investors sell before the maturity period, they have to sell on the exchanges and generally, FMPs trade at a discount to the NAV in the exchanges. Contrary to the above, TMFs are open-ended in nature, so investors can enter even after the NFO time window is over. Similarly, they can exit at any time before the maturity period by selling their units at the NAV to the fund house and not on the exchange.
Though TMFs have many advantages compared to FMPs, the major drawback is that such funds lack performance history and track record. Further, if investors exit before the maturity period they may be affected by interest rate movements. As investments are limited to specific maturity and to specific constituents, the fund managers really do not have much scope to improvise the returns.
To conclude, TMFs are best suited for investors who have an investment horizon of five or six years and have a conservative investment style.
The writer is a professor of finance & accounting at IIM Tiruchirappalli