Target maturity funds vs Fixed maturity plans: Which is better?

Stock markets have been hitting highs despite RBI increasing the benchmark rates regularly since May 2022 including the recent hike of 35 basis points taking the repo rates to 6.25 per cent leaving investors wondering whether it is wise to invest at these levels. Yields on debt securities have been hovering around 7.30 per cent and with RBI indicating that it may pause hiking rates as inflation shows signs of falling, the interest rate cycle may have peaked out. And this may be the right time to invest in debt securities or debt mutual funds. Financial planners are advising investors to invest in Target Maturity Funds or TMFs wanting to lock in at the current yields. TMFs have become very popular with investors and Asset Management Companies (AMCs) have launched a series of TMFs to cater to investor sentiments and are currently managing assets (called assets under management) worth Rs 1.2 lakh crores.

What are TMFs? How different are they from Fixed Maturity Plans (FMP)?

Let’s try to demystify them in the following paragraphs:

What are TMFs and TMPs?

TMFs are open-ended funds and typically invest in PSU bonds, AAA-rated corporate bonds, government securities, and state-development loans (SDLs) that are held till maturity. They are either index funds or ETFs or Fund of Funds. For example, an AMC launched an open-ended TMF recently which will invest in securities of the Nifty G-Sec June 2036 index.

On the other hand, Fixed Maturity Plans (FMP) are close-ended debt funds that invest in certificate of deposits, corporate bonds, commercial papers, money market instruments, non-convertible debentures, and government securities and have a fixed maturity period say for example 1170 days, 380 days etc. An investor can invest in FMPs only during the NFO period and can exit from the fund only through the exchange on which it is listed.

Expected returns

FMPs cannot provide indicative yields, but you can expect the current yield if you hold them till maturity. In the case of TMFs also you can get the current yields if you hold them till maturity.

For example, if you had invested in the Bharat Bond Exchange Traded Fund (ETF) - April 2033 which closed recently, you can expect a return of around 7.50 per cent which is the benchmark index’s yield to maturity of 7.50 per cent minus the expense ratio of 0.0005 per cent.

Risks in TMFs and FMPs

Since FMPs invest in securities that mature in line with the maturity of the scheme and are close-ended, the fund manager does not churn the portfolio as he does not face any redemption pressures. And because of the very nature of FMPs, the investor does not face any interest rate risk. However, if the fund manager holds low-rated securities in the portfolio to give high returns to investors or if the credit rating of securities that the fund holds is downgraded, the investor is exposed to credit risk. Investor confidence did take a hit when a few FMPs turned bad a few years back. In the case of TMFs, the default risk is less as the fund invests in G-Secs, SDLs and AAA-rated Bonds. Interest rate risk will be nil if the investor stays invested till maturity in TMFs.

Who should invest?

If you are a risk-averse investor and want a higher return than a bank FD or tax-free bonds, TMFs are ideal investment options. But make sure that your investment horizon is more than three years to get the benefit of indexation and get a higher post-tax return than FDs. Unless you need money very badly make sure that you hold them till maturity since redeeming them before maturity will impact your returns due to volatility in interest rates. Including FMPs and TMFs in your portfolio is also a great way to diversify your portfolio. However, looking at the portfolio composition and the yields are advisable.

Tax aspects

TMFs and FMPs are both taxed like debt mutual funds. Short-term capital gains will arise if they are held for less than 36 months and taxed as per your income tax slab rates i.e., 5 per cent, 20 per cent, or 30 per cent. Long-term capital gains are applicable if the asset is held for more than 36 months. You need to pay 20 per cent tax after claiming indexation benefits, reducing your tax liability by factoring in inflation in the purchase price.

(The author is a CFA and a former banker, currently teaches at Manipal Academy of Higher Education, Bengaluru)