Boring but important in portfolio construction. Do pay attention.
There is a long list of investment options in markets. But not all investment options suit investors. Just like each finger on our hands is unique, so are investment needs and options available to fulfil those needs. Before selecting an investment options, you have to be clued into external realities which may have a bearing on your investments. Presently, there are investors who are concerned about low interest rates on fixed income and rising volatility in the stock market. There are investors who invest some portion of their savings in fixed income instruments which offer relatively stable returns and protect capital. It pinches a lot to invest in a fixed deposit or bond, especially if your income falls in a high-tax bracket. For such conservative investors, investing in Target Maturity Funds (TMF) and select Fixed Maturity Plans (FMP) may fetch handsome post-tax returns. Let us understand these aspects in a greater detail:
Mutual fund houses offer TMFs and FMPs to investors. Both have a pre-determined maturity date. These schemes invest in bonds that mature before the date of maturity of the scheme. In case of TMF, they tend to track an underlying index which constitutes some high quality (low credit risk) bonds such as government securities or bonds issued by public sector undertakings In case of an FMP, a fund manager selects bonds of good quality issuers that mature in line with scheme’s maturity.
TMF is an open-ended scheme. FMP, on the other hand, is a closed-ended one. To put it simply, you can invest in TMFs anytime during the tenure of the scheme and sell it any time you want. FMP however allows entry at the time of new fund offer only. Though units are listed on a stock exchange, they rarely trade on a stock exchange. So, effectively you have to remain invested till the maturity of the scheme.
These schemes invest in high-quality bonds. Hence, there is little credit risk. One’s capital is not at risk and the scheme gets regular interest income on bonds held. Most of these schemes have a tenure of five to six years. The interest payable on many of these high quality bonds maturing in five to six years, hover around 6.5%. Even if you provide for an expense ratio of around 25 to 50 basis points, you are more likely to get net yields of more than 6%. These schemes are not a perfect substitute for fixed deposits. But they offer pay-offs akin to a cumulative fixed deposit. Bonds are bought by a fund manager and held till maturity. The return on these bonds decides the scheme’s returns and hence there is high visibility on expected returns from these FMPs and TMFs though they are mutual fund schemes.
In the past one year, a view that is gathering strength is a possibility of a hike in interest rates. Interest rates have inched up at a snail’s pace. And in India, they are more likely to continue inching up slowly. For all those investors, who wait in short-term bank fixed deposits for interest rates to go up, after which they want to invest in long term fixed income options, this is an alarm bell. Rates on short-term fixed deposits (six months are not rewarding at all. You will be better-off investing in a medium-term mutual fund and pocket better returns than remaining invested in a short-term product with an expectation that you will get to deploy your money at a future date.
The biggest positive of investing in medium duration TMF and FMP is the indexation benefit they offer. The gains earned on the units of bond funds held for more than three years, are considered as long term capital gains. These gains are taxed at 20 percent rate of tax after adjusting the cost of the units for indexation. If you invest now (before March 2022) and the scheme matures in, say, June 2027 then you are entitled for six indexation benefits. If you invest in April 2022, then you are entitled for five indexation benefits, not bad though.
Indexation benefit cuts down your tax liability as it accounts for inflation. Inflation that eats into your purchasing power in real life, here acts on your side and helps to bring down the tax liability. Most medium-duration TGFs can offer attractive post-tax returns with very little tax liability. If you invest in a fixed deposit then the interest earned on the fixed deposit gets added to your income and is taxed according to the tax slab rate, which can be as high as 40 per cent.
Investing in the target maturity schemes provides dual-benefit of – capital protection and attractive post-tax returns. Investments in these schemes can be used to fund your down payments of your house, car or overseas vacation. These schemes can also be complementary to your investments in equity mutual funds which may be used for long-term goals such as retirement or child’s education.
Just posted a photo # Money Honey Financial Services Pvt. Ltd. https://t.co/sxxkg05KyM— MoneyHoney (MoneyHoneyMH) March 24, 2022
Just posted a photo # Money Honey Financial Services Pvt. Ltd. https://t.co/1JPxhdyVKm— MoneyHoney (MoneyHoneyMH) March 24, 2022