Target Maturity Funds can offer “Fixed Deposit Plus” Returns

Recently, Target Maturity Funds (TMF) are gaining popularity in India, thanks to interest rate increase. Over 50 TMFs are launched since 2022. Let’s understand why TMFs are attractive and how they can help you to make FD-plus returns.

First thing first, what is Target Maturity Fund

A Target Maturity Fund is an open-ended mutual fund that invests in a portfolio of fixed-income securities, such as government securities, PSU bonds, SDLs and AAA-rated corporate paper that are held to maturity. It follows a passive roll-down strategy with a defined maturity date and asset allocation.

These funds are designed to provide investors with a fixed investment horizon and are often used as an alternative to traditional fixed income investments, such as fixed deposits.

How much TMFs can deliver?

Like Fixed Deposits. TMFs have a pre-defined maturity date & also, at the time of investment, one can understand the approximate return on the investment. That is, if we stay invested in the fund until maturity, the returns we receive will be comparable to the Net YTM (yield-to-maturity) at the time of investment. The Net YTM is calculated by subtracting the fund’s expense ratio from its YTM at the time of investment.

How TMFs can be better than FD

With the recent rise in Interest rates, banks too have increased the FD rates but taxation of it plays the spoilsport.  Fixed deposits do not offer any indexation benefit. They are taxed as per your slab irrespective of how long you stay invested.  This means the returns from FD will be taxed higher if you are in a higher tax slab. In contrast, TMFs offer indexation benefits.  Indexation benefit is applicable for debt mutual funds if you hold the investment for atleast 3 years.

Illustration

Particulars Fixed Deposit Target Maturity Fund
Investment Amount (Jan 2020) 10 Lakhs 10 Lakhs
Assumed Rate of Return* 7% 7%
Holding Period 3 Years 3 Years
Indexation NOT AVAILABLE AVAILABLE
Value on Maturity (2020-2021) ₹ 12,25,043 ₹ 12,25,043
Indexed Cost** NA ₹ 11,45,329
Taxable Amount ₹ 2,25,043 ₹ 79,714
Applicable Tax %*** 30% 20%
Tax ₹ 67,513 ₹ 15,943
Post Tax Value ₹ 11,57,530 ₹ 12,09,100
Net Post Tax Return 4.90% 6.53%

Note:
* Fixed deposit returns/TMFs YTM were different during the above said period. For illustration purpose, we have assumed the return of investment from FD/TMFs as 7%.
** Cost-Inflation Index: 2019-20: 289 & 2022-23: 331
*** Considering the investor is in higher tax slab.

Do you know?

In the above illustration, if the same investor hold for another 2 months. That is, till April 1st, he/she will be eligible for one more indexation year and thus the tax reduces further.

Why Should You Invest In Target Maturity Funds Now?

When interest rates are close to peaking out or if it peaks out, passive debt strategies generally tend to do well. In 2020 and 2021 interest rates were low due to the pandemic & thus, the yield of debt funds was also impacted due to lower accrual. However, with recent increase in Interest rate and nearing its peak, the Target Maturity Funds become attractive given the higher YTM and significant tax advantage through indexation. So, entering in February & March gives you a edge as most of the long-term TMFs are aimed at getting one additional year in indexation benefit.

Who can avoid TMFs

Investors who do not hold the fund to maturity, then the volatility in interest rates will affect the investment. So, you might end up getting less returns.