Can Target Maturity Funds Be Your Alternative to Bank Fixed Deposits?

The Reserve of India (RBI) gradually increased interest rates, taking the repo rate from 4% at the beginning of 2022 and concluding it at 6.25% at the end of 2022. The Monetary Policy Committee (MPC) recently decided in its meeting on February 08, 2023, to increase the policy repo rate under the liquidity adjustment facility (LAF) by 25 bps to 6.50% with immediate effect on the basis of an evaluation of the existing and changing macroeconomic environment. The purpose of RBI's abrupt hike in interest rates during this brief period was to contain inflation and prevent economic overheating in the face of hazy global economic conditions.

Correspondingly, the bond yields have also risen across the curve. With the recent inflation readings coming in below predictions, inflation is now in the rear-view mirror and has started to slow down. Looking forward, returns from fixed-income investments may stabilise as the RBI is anticipated to halt the cycle of rate hikes.

When it comes to fixed-income investments, the majority of risk-averse retail investors believe that Bank Fixed Deposits (FDs) are the best way to generate returns and ensure the complete safety of the invested principal. However, due to the drop in FD interest rates in the past few years, there has been a noticeable shift of investors into debt mutual funds.

The last two years have not been easy for debt fund investors as rising yields have reduced bond fund returns. Debt fund investors may anticipate a better experience as we move towards a standstill in rate hikes, followed eventually by rate cuts. Bond rates at their current levels can be a good opportunity to invest in debt mutual funds. Under debt-oriented mutual funds, there are a variety of categories that could offer a better opportunity of returns than FDs. Such an opportunity exists with Targeted Maturity Funds. Target Maturity Funds should be a part of your portfolio if you don't want to take on a lot of risks but are eager to find an alternative to FDs.

Although the comparison is not exactly apples-to-apples, there are many similarities between Bank FDs and Target Maturity Funds (TMFs).

In 2022, Target Maturity Funds (TMFs) and Fixed Deposits both gained wide appeal. Investors in a higher tax bracket may find it challenging to choose which investment is better, while FD rates and bond yields have increased significantly this year. This article elucidates if Target Maturity Funds can be used as an alternative for Bank FDs.

What are Target Maturity Funds?

Targeted Maturity Funds (TMFs) are debt funds with passive management that follow an index of underlying bonds. The asset management company (AMC) invests in a variety of bonds as opposed to just one, assisting in diversification. The maturity of these funds is pre-defined. By purchasing a target maturity fund, an investor can lock in an interest rate and profit from it regardless of how the general economy performs, but only if they hold the fund until maturity. Target Maturity Funds are open-ended and liquid. Although there is no lock-in period, investors are advised to use the Buy and Hold (to maturity) approach to maximise profit.

Targeted Maturity Funds, a fixed-income strategy, may not be as popular as equity investments, but a smart investor with a medium- to long-term investment horizon can wisely use TMF to generate steady returns with moderately lower volatility.

Why consider Target Maturity Funds at this juncture?

For goal-based investing, Target Maturity Funds are appropriate investment vehicles since your investment horizon aligns with the fund's maturity. TMF, in particular, becomes a desirable investment option when the economy experiences high interest rates since it enables you to lock in current rates that will be paid during the maturity term, even if interest rates fall in the future.

Considering the limited spreads of AAA Corporate Bonds and SDL over government securities, investors may consider looking at funds having a duration of 3-5 years with predominant sovereign holdings as they may offer a better risk-reward. For investors seeking a comparatively secure and liquid route to benefit from the present prevailing yields, Target Maturity Funds with a predominance allocation to government-backed assets such as G-Secs, PSU Bonds, Corporate Bonds, and SDLs are an excellent option.

These schemes are passively managed with a roll-down strategy in which bonds are held till maturity, mitigating the interest rate risk to some extent, but not entirely, which offers lower volatility. In TMF, on maturity, you get back the face value of the bond, which is independent of market price changes at that time.

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Let's have a look at how TMFs and FDs compare as investment options:

• Risk Profile - FDs are thought to be quite secure; however, the security of your investment is contingent upon the well-being of the organisation providing the investment option. If you look for lower-rated corporates which offer you higher rates on your FD, you may end up facing defaults, as witnessed by many investors in the past. On the other hand, a high degree of safety is provided by the sovereign and quasi-sovereign status of the bonds owned by TMFs.

• Return Expectations - As we all know, the market is prone to fluctuations, there cannot be an assured return for TMFs which can be compared with FDs, but there is a high degree of visibility of returns in TMFs. Although TMFs are inherently low-risk in nature, they still allow you to participate in the market's potential growth and earn substantial returns. When you invest in FDs, you may only expect to get the returns that the bank or the underlying corporation has promised.

• Liquidity - Target Maturity Funds have higher liquidity as you can redeem the units anytime, subject to exit load charges. Withdrawing from fixed deposits before maturity attracts penalty charges, and you either have to break your fixed deposit or take a loan against your fixed deposit, which can be costly. 

• Tax Implication - If you are in a higher income tax bracket, you may invest in Target Maturity Funds. It is taxed similarly to debt-oriented funds. If the holding period is less than 3 years (STCG), then gains are added to the investor's total taxable income and taxed as per the slab rate. But, if the holding period is more than 3 years (LTCG), the gains are taxable at 20% with indexation benefits.

  In contrast, the interest income produced on fixed deposits is completely taxable according to your tax bracket. Please be aware that banks deduct tax at source from your account when crediting interest payments that total more than Rs 40,000 for individuals (in the case of senior citizens the threshold is Rs 50,000).

So, compared to bank fixed deposits, your investment in Target Maturity Funds is tax-efficient. Target Maturity Funds feature the indexation benefit, which lowers taxes and increases post-tax yields.

Should you consider Target Maturity Funds as an alternative to Bank FDs?

You may invest in Target Maturity Funds as an alternative to Bank FDs only if it matches your investment objectives and risk tolerance. You may invest in target maturity funds only if you can hold them until maturity. For those with higher income tax rates, it might be a better option than fixed deposits, given its portfolio of high-quality bonds. You may avoid these funds if you cannot hold them until maturity or fall in the lower income tax bracket.

Target Maturity Funds are a reliable, low-risk investment choice if you have goals coming up in the next 3-5 years. You have the option of investing in lumpsum or over time with a SIP. Simply said, you may deploy a modest percentage of your portfolio to Target Maturity Funds and then progressively increase it as you gain more understanding of these funds.

Keep in mind that Target Maturity Funds are relatively new in India, so you might not have access to enough historical data to evaluate their performance. The tracking error, or discrepancy between the actual return and that of the related benchmark, maybe a risk for Target Maturity Funds.

To conclude...

Investing only in equity-oriented instruments doesn't always mean staying ahead of inflation. The optimal way to go forward is to have the appropriate asset allocation model based on the investor's risk tolerance and goals. One can build a well-diversified portfolio to sustain various market phases by investing across asset classes like equity, debt, gold, etc., based on their financial goals.

MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.

She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.