Are target maturity funds better than bank FDs?

Today, several public and private sector banks are offering 5.25 – 5.75% p.a. on their FDs of 3-5 years, as shown by BankBazaar data. In comparison, many TMFs of similar maturity are giving returns of 5.6 – 6.2% to those who stay invested till the fund maturity (data till February-end 2022).

Holding period matters

TMFs offer a huge tax advantage over FDs to those with an investment horizon of at least three years. Your return-of-capital gains from TMFs, if any, when you redeem your investments for three years or more after indexation gains are levied 20% plus 4% cess. Under indexation, your capital gain is calculated as the difference between the selling price of TMF units and the indexed cost of their purchase (i.e., adjusted upward for inflation using the government’s cost inflation index). This reduces your capital gains for taxation purposes. On the other hand, interest income from FDs is taxed at your income tax slab rate plus 4% cess.

However, short-term capital gains (holding period of less than three years) from TMFs are taxed in the same way as FD interest income. Hence, for such short tenures, TMFs may not offer post-tax return benefits on FDs.

quality matters

Today, all TMFs are investing in G-secs (GoI bonds), SDLs (state development loans or government bonds), AAA-rated bonds or a mix of these. This makes TMFs, especially those focusing on government securities and SDLs, less risky, expressly or otherwise, of central government guarantees for these instruments.

Corporate trainer and author, Joydeep Sen says that FDs with major public and private sector banks can also be considered as low-risk. However, an FD with a bank with weak financial position may not be equally safe, except to the extent of deposit insurance cover up to a maximum of Rs. 5 lakh per bank.

Ease of premature exit

Premature exit from bank FD attracts penal interest rate. The exit from TMF comes without any restrictions and you can redeem your investment any time before maturity.

However, premature exit from TMFs can expose you to interest rate risk – in a rising rate environment, bond prices tend to fall, resulting in a fall in the NAV of debt funds like TMFs. As Sen points out, it is a choice between the limited penalties of bank FDs versus the unknown interest rate risk of TMFs.