Target Maturity Funds Explained: Returns, Taxation, Risks and Who Should Invest?

What Is a Target Maturity Fund?

If you have been looking for an alternative to fixed deposits, chances are you have come across Target Maturity Funds (TMFs). Over the last few years, these funds have gained popularity because they offer something many investors want, better visibility of possible returns without locking money into a bank deposit.

Naturally, this raises a few questions.

• Are TMFs safer than regular debt mutual funds?
• Do they guarantee returns like fixed deposits?
• If both debt funds and TMFs invest in bonds, what's the difference?

Let's understand.

A TMF is a debt mutual fund that invests in bonds maturing around a specific target date. It can be structured as an Exchange Traded Fund (ETF) or as a Fund of Funds (FoF) that invests in an underlying target maturity ETF. For example, the Bharat Bond Fund is a Target Maturity Fund, with both ETF and FoF variants available to investors.

For example, a 2030 Target Maturity Fund will primarily invest in bonds that mature around 2030. These may include Government Securities (G-Secs), State Development Loans (SDLs), PSU bonds and in some cases, highly rated corporate bonds.

Unlike actively managed debt funds, where the fund manager frequently buys and sells bonds, TMFs generally follow a buy-and-hold strategy. The fund buys a portfolio of bonds linked to a particular maturity year and largely holds them until those bonds mature.

How Do Target Maturity Funds Work?

When you invest, your money is pooled with that of other investors and used to buy a portfolio of bonds. These bonds pay regular interest, known as coupon payments and eventually repay their principal when they mature.

As time passes, three things happen simultaneously,

• The bonds continue to earn interest.
• The time left until maturity keeps reducing.
• The fund gradually becomes less sensitive to interest-rate movements.

Eventually, when the target maturity date arrives, the bonds mature and the proceeds are distributed to investors after the fund is wound up.

Since the portfolio is largely held until maturity instead of being actively traded, investors usually get greater visibility of the likely outcome than they do with many actively managed debt funds.

What Do Target Maturity Funds Invest In?

The exact portfolio depends on the index the fund tracks, but most TMFs invest mainly in high-quality debt securities such as:

• Government Securities (G-Secs)
• State Development Loans (SDLs)
• Public Sector Undertaking (PSU) bonds
• AAA-rated corporate bonds

Many TMFs have a significant allocation to government-backed securities, which generally makes them less exposed to credit risk than debt funds that invest heavily in lower-rated corporate bonds.

What Returns Can You Expect from TMFs?

Unlike fixed deposits, TMFs do not promise a fixed return. Instead, fund houses display a number called the Yield to Maturity (YTM), which many investors mistake for the return they will definitely earn.

YTM is an estimate of the annual return the underlying bond portfolio may generate if everything goes according to plan. For this estimate to hold true, a few assumptions are made,

• The bonds are held until they mature.
• All interest (coupon) payments are received on time.
• Those interest payments are reinvested at similar rates.
• The portfolio remains broadly unchanged until maturity.

In reality, these assumptions may not always hold. Changes in interest rates, fund expenses, portfolio rebalancing, reinvestment rates, cash holdings and tracking error can all cause your actual returns to differ slightly from the YTM displayed by the fund.

That's why YTM should be viewed as an indicator, not a promise. Historically, investors who stay invested until the fund matures have generally seen returns influenced by the yield environment prevailing when they invested. In other words, TMFs offer more predictable outcomes than many debt funds, but not guaranteed returns.

Are TMF Returns Really Predictable?

You will often hear that Target Maturity Funds offer predictable returns. But predictable and guaranteed are not the same thing. The bonds held by a TMF pay a fixed rate of interest. However, the market value of those bonds changes every day as interest rates move.

If interest rates rise, newly issued bonds offer higher yields. As a result, existing bonds become less attractive and their prices generally fall. This can reduce the fund's Net Asset Value (NAV). On the other hand, if interest rates fall, older bonds paying higher interest become more valuable, and bond prices generally rise. This may increase the fund's NAV.

This means the value of your investment can move up or down before maturity. Another point to remember is that the fund's displayed YTM also changes over time because bond prices keep changing.

So why are TMFs considered relatively predictable?

The answer lies in their structure. Since these funds have a fixed maturity date and largely hold their bonds until maturity, temporary price fluctuations tend to become less important over time. For investors who remain invested until the fund matures, the final outcome is generally easier to estimate than in actively managed debt funds.

Are Target Maturity Funds as Safe as Fixed Deposits?

Many investors compare TMFs with fixed deposits; however, they work quite differently. A fixed deposit (FD) offers a fixed interest rate at the time of investment. If you hold it until maturity, you know exactly how much you will receive, provided the bank remains financially sound. (Bank deposits are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC) up to ₹5 lakh per depositor per bank.)

A Target Maturity Fund, on the other hand, doesn't guarantee either your returns or your principal. Although it invests in bonds that pay regular interest, the market value of those bonds changes every day. As a result, the fund's NAV can move up or down before maturity.

That said, if you stay invested until the fund matures, the impact of these short-term price movements usually reduces, making the eventual outcome more predictable than many other debt funds.

Also Read - What is Mark to Market In Mutual Funds?

Target Maturity Funds vs Fixed Deposits

What Are the Risks of Target Maturity Funds?

Although TMFs are generally considered lower-risk investments, they are not risk-free. Before investing, it's important to understand the risks involved.

Interest Rate Risk

Interest rates and bond prices move in opposite directions. When interest rates rise, existing bond prices usually fall, which can reduce the fund's NAV. Similarly, when interest rates fall, bond prices generally rise, pushing the NAV higher. If you remain invested until maturity, these temporary fluctuations usually have a smaller impact on your overall returns.

Credit Risk

Credit risk refers to the possibility that a bond issuer may fail to pay interest or repay the principal on time. The good news is that most Target Maturity Funds in India primarily invest in Government Securities (G-Secs), State Development Loans (SDLs) and PSU bonds. These are generally considered safer than lower-rated corporate bonds, so credit risk is usually lower than in many actively managed corporate bond funds. However, lower risk doesn't mean zero risk. Some TMFs also invest in highly rated corporate bonds, so it's always worth checking the fund's portfolio before investing.

Liquidity Risk

TMFs are open-ended funds, which means you can redeem your investment before maturity. However, if you exit early, the amount you receive will depend on the prevailing bond prices. This means you could receive more, or less than what you originally invested.

Reinvestment Risk

The bonds held by the fund pay periodic interest. If these coupon payments are reinvested at lower interest rates than expected, the fund's overall returns may be slightly affected.

How Are Target Maturity Funds Taxed?

For investments made on or after 1 April 2023, gains from most debt mutual funds, including Target Maturity Funds, are taxed according to the investor's income tax slab, regardless of how long the investment is held.

Earlier, investors could claim indexation benefits on long-term debt mutual funds, which often made them more tax-efficient than fixed deposits. That benefit is no longer available for most new investments.

Interest earned on bank fixed deposits is also taxed according to the investor's income tax slab. So, from a tax perspective, TMFs no longer enjoy the advantage they once had over FDs. Instead of comparing only the pre-tax returns, investors should compare the post-tax returns, liquidity, flexibility and their own investment goals before choosing between the two.

Target Maturity Funds vs Debt Mutual Funds

A common question investors ask is:

"If both invest in bonds, why not simply buy a debt mutual fund?"

The biggest difference lies in how the fund is managed. A Target Maturity Fund follows a passive investment strategy. It buys bonds maturing around a particular year and largely holds them until maturity. A traditional debt mutual fund is actively managed. The fund manager can buy and sell bonds, change the portfolio's maturity profile and adjust investments based on expectations of future interest-rate movements.

A fund manager may outperform a TMF if interest-rate decisions work in their favour. However, active management also introduces more uncertainty. TMFs take a rules-based approach, making them easier to understand and more predictable for investors who plan to stay invested until maturity.

Why is Macaulay Duration Important in Target Maturity Funds?

Macaulay Duration is the average time it takes for a bond investor to recover the invested amount through interest payments and principal repayment. It is also a key measure of a debt fund's sensitivity to interest rate changes.

In a Target Maturity Fund, the Macaulay Duration gradually reduces as the fund approaches its maturity date. As a result, the fund becomes less sensitive to interest rate movements over time. If you plan to stay invested until maturity, short-term interest rate fluctuations are generally less of a concern. However, if you intend to redeem your investment before maturity, checking the Macaulay Duration can help you understand the fund's interest rate risk.

TMF ETF vs TMF Fund of Fund (FoF)

TMFs are available in two different formats, Exchange Traded Funds (ETFs) and Fund of Funds (FoFs). A TMF ETF is listed on the stock exchange and can be bought or sold during market hours, just like a share. To invest, you will need a demat and trading account.

A TMF Fund of Fund (FoF), on the other hand, simply invests in the underlying TMF ETF. It works like any other mutual fund, so you can invest directly through your mutual fund platform without opening a demat account.

Also Read - What is Fund of Funds?

For retail investors, the choice comes down to convenience. If you already invest through a demat account, an ETF may suit you. If you prefer SIPs and the simplicity of mutual funds, a FoF is often easier.

Is Bharat Bond ETF a Target Maturity Fund?

Yes, but it's important to understand the difference. Bharat Bond ETF is one of India's best-known Target Maturity ETFs. It invests primarily in bonds issued by public sector companies and follows a fixed maturity structure.

However, Bharat Bond is just one example of a Target Maturity investment, not the entire category. Many other TMFs invest in Government Securities, State Development Loans, PSU bonds or a mix of high-quality debt instruments, depending on the index they track.

Frequently Asked Questions

Are Target Maturity Funds better than Fixed Deposits?

TMFs may offer higher returns than FDs because they invest in government securities and high-quality bonds. However, unlike FDs, returns are not guaranteed and the fund's NAV can fluctuate before maturity.

What returns can investors expect from Target Maturity Funds?

TMFs do not guarantee returns. However, investors can use the fund's Yield to Maturity (YTM) as an indication of the return potential if the fund is held until maturity. Actual returns may differ due to changes in interest rates, expenses, and portfolio movements.

Can investors exit a Target Maturity Fund before maturity?

Yes. TMFs are open-ended funds and investors can redeem their units before the maturity date.

How are Target Maturity Funds taxed in India?

Target Maturity Funds are taxed as debt-oriented mutual funds. Investors should check the latest tax regulations before investing.

Do Target Maturity Funds benefit when interest rates fall?

Yes. Bond prices generally rise when interest rates fall. Since TMFs invest in bonds, their NAV may increase during periods of declining interest rates.

What happens when a Target Maturity Fund reaches maturity?

When the fund reaches its target maturity date, the underlying bonds mature and the proceeds are returned to investors. The fund house generally credits the redemption amount to investors' bank accounts after the scheme matures.