What are Target Maturity Funds?

What are Target Maturity Funds?

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?

• Target maturity funds can invest only in Government Securities (G-Secs), State Development Loans (SDLs) and PSU bonds that mirror an underlying bond index. Therefore, the credit quality of target maturity funds is very high.
• Target maturity funds hold the bonds in their portfolio till maturity and roll down or reduce the maturities of their bonds. Rolling down maturity means that the maturity or duration of a bond portfolio reduces over time. So, if you buy a 5 year bond with the objective of holding till maturity, after 1 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 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

• 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.
• 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.