Target maturity funds are passive debt mutual fund schemes, tracking an underlying bond index. Unlike other open ended mutual fund schemes, target maturity mutual funds have defined maturity dates. On the maturity
date, investors holding units of target maturity funds will get the principal amount along with accrued interests. Target maturity funds can be either exchange traded funds or index funds.
How do target maturity funds work?
- As per SEBI regulations, target maturity funds can invest only in Government Securities (G-Secs), State Development Loans (SDLs) and PSU bonds that mirror an underlying bond index. G-Secs enjoy sovereign status.
SDLs also enjoy quasi sovereign status because the interest and principal payments come from the State Government’s budget. PSU bonds also enjoy near sovereign status because PSUs are owned by the Government. As a result,
the credit quality of target maturity funds is very high.
- Target maturity funds hold the bonds in their portfolio till maturity and roll down the maturities of their bonds. Rolling down maturity means that the maturity or duration of a bond portfolio reduces over time.
For example, if you buy a 5 year bond with the objective of holding it till maturity, after one year the 5 year bond will become a 4 year bond, after 2 years it will become a 3 year bond, so on so forth.
- The yield curve is usually upward sloping, implying that longer the maturity higher is the yield e.g. the yield of a 5 year bond will usually be higher than yield of a 4 year bond. On the other hand, interest rate risk
is directly related to maturity or duration of a bond e.g. 5 year bond will have higher interest rate risk compared to a 4 year bond. If you roll down the maturity, you continue to get higher yield on your portfolio,
even though your portfolio risk reduces with shortening maturity or duration. This makes target maturity mutual funds good investment options for investors especially in an environment when interest rates or
yields are high, and are expected to come down in the future.
- The bonds in the target maturity funds’ portfolios pay regular interest (coupons) and the principal (face value) on maturity. The coupons paid by the bonds are re-invested in the fund. So investors keep accruing interest
and benefit from compounding.
Advantages of target maturity funds
- Even though target maturity funds seem similar to fixed maturity plans (FMPs), there is an important difference between the two. FMPs are close ended schemes, while target maturity funds are open ended schemes. You can
sell or redeem units of target maturity ETFs or index funds at any time on stock exchanges (in case of ETFs) or with the asset management companies (in case of index funds). Target maturity funds offer high liquidity
compared to FMPs.
- You can lock-in current yields over maturity period by investing in target maturity funds, provided your investment tenure matches with the target maturity date. Since the bonds are held till maturity (rolling down
maturity), you will continue to get the yield even if interest rates / yields come down in the future.
- If the target maturity date is more than 3 years from your date of investment in a target maturity fund, you can get the benefit of long term capital gains taxation. Long term capital gains in debt mutual funds are taxed
at 20% after allowing for indexation benefits.
We discussed what are target maturity funds. Investors should consult with their mutual fund distributors or financial advisors, if target maturity funds are suitable for their fixed income investment needs.
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