What Are Target Maturity Funds? How Are They Taxed?

Target maturity funds (TMFs) are debt mutual fund schemes akin to equity index funds. However there is a difference, because these funds track an underlying bond index. Thus making these schemes a passive investment option in debt funds.

As the name contains the word 'target', the portfolio of TMFs consists of bonds that are part of underlying bond index having defined maturity dates. The bonds of the portfolio are held till maturity and the interest paid during the holding period is reinvested in the fund.

At the time of maturity, investors having units of target maturity funds will get the principal and the accrued interest. TMFs are open-ended schemes that can be either exchange traded funds or index funds. Thus they have greater liquidity.

How do target maturity funds work?

The portfolio a target maturity fund is almost homogeneous, i.e. the bonds held in the portfolio have almost a similar maturity date as the fun's stated maturity. By holding on to the bonds till they mature, the duration of fund declines with receding time and hence investors are less prone to price fluctuations caused by changes in interest rate.

So these funds roll down the maturities of the bonds held. Rolling down mean, the maturity or duration of a bond portfolio reduces over time. For instance, if a 5 year bond is held till maturity, after a year, this 5 year bond becomes 4 year bond, after two years it becomes 3 year bond and so on. The gradual changing is called as rolling down.

The yield from these funds continue to be higher even, even though the portfolio risk reduces with shortening maturity or duration, if you roll down the maturity. Therefore the yield curve is upward sloping, implying that longer the maturity higher is the yield. But interest rate risk is directly related to maturity or duration of a bond. This makes target maturity mutual funds good investment options, especially when the interest rates are high and are expected to reduce in future.

Plus the bonds held in the portfolio of a target maturity fund pay regular interest and principal on maturity. The interest is re-invested, gets accrued, and compounded.

TMFs are currently mandated to invest in government securities, public service union bonds(PSUs), and SDLs (State Development Loans). They carry lower default risk compared to other debt funds. Also, because of its open-ended structure, investors can choose to withdraw his/her investment in case of any adverse development around the bond issuers, probably a default or a credit downgrade.

Taxation on Target Maturity Funds
The tax on target maturity funds is of debt funds. Schemes with maturity longer than 3-years are eligible for long term capital gains (ltcg) tax at 20% with indexation (gains over and above inflation is taxable).

Benefits of Target Maturity Funds

• Highly liquid as they are open-ended, easily one can redeem or sell units of TMF on stock exchange as trading stocks.
• Lock-in yields, irrespective of the change in interest rates, the portfolio of TMFs will be as per the maturity date. So, if units are held till maturity investor will definitely get the yield/ interest rate stated.
• Tax benefit only if the target maturity date is more than 3 years.