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Target maturity funds vs Tax free bonds: Where should you bet?


Expert 1: Mr. Dhaval Kapadia, Director – Managed Portfolios, Morningstar Investment Adviser India

Tax free bonds are bonds issued by various PSU entities with tenors of 10 to 20 years where the interest earned is exempt from tax. The last set of tax-free bonds were issued a few years since there has been no fresh issuance. These tradable in the secondary bond market. Target maturity funds are debt mutual funds that invest specified government securities or corporate bonds or state development loans/securities or a mix of them and typically hold these bonds to maturity. Hence, it’s a portfolio of bonds vs tax free bonds which are individual securities.

Pros and cons of investing in Target Maturity funds and Tax free bonds

Target Maturity funds


– Portfolio of bonds reduces credit risk and concentration

– Bonds are typically held to maturity thereby reduces interest rate risk in the interim particularly for investors that align their investment horizon with that of the portfolio maturity.

– Low expense ratio (vs other debt funds) due to passive management

– Visibility of returns – since the portfolio invests in specific securities with known yields and holds them till maturity, the visibility of returns at the maturity is better vs other debt funds

– Open-ended funds with easy liquidity since these invest in liquid securities


– If one exits prior to maturity of the underlying securities, the returns may vary

– In case interest rates rise further, there maybe an opportunity loss as one has invested at lower yields. And if one exits to re-invest elsewhere, the returns from the initial investment maybe lower due to adverse yield movement

– Debt mutual fund taxation is applicable. Beneficial only if held for 3 years and more

Tax Free Bonds


– Interest is completely tax free, beneficial mainly for investors in higher tax brackets

– Minimal credit risk as issuers are PSUs


– Limited liquidity in secondary market making it difficult to buy & sell

– Currently, for 3 year+ holding periods post-tax yields / returns on debt funds may be better than tax free bonds as government & corporate bond yields have risen more than those on tax free bonds.

Between Target Maturity funds and Tax free bonds, what would you advise to the investors?

Currently, given that yields on government securities and corporate bonds are higher than the yields on tax free bonds, even on a post-tax basis, investors with a horizon of 3 years & above, can consider target maturity funds.

Expert 2: Nitin Rao,Head Products and Proposition, Epsilon Money Mart

In the current market scenario, investors are looking for safer options with expectations of a decent interest rate and to protect their capital. Investors can explore the options in debt mutual funds which have various categories suitable for different time horizon and low volatile needs. Investors can explore options like Target Maturity Funds which are like tax free bonds in terms of high safety and negligible credit risk. Target maturity funds are passive debt funds which have a specified maturity date and the bonds held in the portfolio are aligned with the maturity date. TMF invests in government securities, psu bonds and AAA -rated corporate papers which are held to maturity. In TMF the investor knows exactly when the scheme will be completed, and the quality of holdings held. Whereas Tax free bonds are the fixed income securities issued by public undertakings offering tax free interest income to investors. The papers held are by PSU focusing on infrastructure related projects. The quality of G-sec holding of TMF has a high credit profile compared to tax free bonds.

If we talk about a time frame & liquidity, investors seeking steady returns and do have liquidity need for longer period say 10-20 years can prefer tax free bonds. Tax free bonds come with lock in period. Whereas TMF 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. Both TMF and Tax-free Bonds have their own pros & cons. The investors should consider all the factors before making any investment decision. Investors should seek the advice of their financial advisor regarding the proportion to be allocated in their portfolio depending on their needs and expectation towards return and investment time horizon. Both the avenues are suitable for those who expect steady returns and have a conservative approach towards market volatility.

Expert 3: Dr. Suresh Surana, Founder, RSM India

In accordance with SEBI regulations, target maturity funds are such funds which can invest only in Government Securities (G-Secs), State Development Loans (SDLs), PSU bonds, etc. Target maturity funds are passively managed debt funds with specified maturity period. One of the major benefits is that these are open ended funds that can be redeemed at any time before the maturity. However, these funds yield higher return as the target maturity period increases. The interest received over the maturity period is reinvested in the fund.

On maturity, the proceeds from the fund would be subjected to tax as short term capital gain or long term capital gain depending on the period of holding. If the period of holding from the date of investment in the target maturity fund upto the target maturity date is more than 3 years, then gains arising from the same would be classified as long term capital gains and would be subjected to tax @ 20% u/s 112 of the IT Act after availing the benefit of indexation. However, if such period of holding is upto 3 years, such gains would be categorized as short term capital gains and taxed as per the applicable slab rates applicable to the investor.

An investor can also choose to invest in tax free bonds which are issued by the government at fixed rate of interest. Just like target maturity funds, tax-free bonds can be redeemed before maturity or on completion of tenure.

With regards to the tax implications, the interest received on the tax-free bonds are exempt from tax. However, the capital gains, if any, on the maturity or redemption of tax-free bonds are subject to taxes under the IT Act. Further, if such bonds are held for more than 12 months, the gains arising from the same would be subject to tax @ 10% u/s 112 of the IT Act. Such gains would not enjoy any indexation benefit. In case the same is held for upto 12 months, the same would be taxable as per the applicable slab rates of the investor.

Expert 4: Mr. Arun Kumar, VP and Head of Research, FundsIndia

Tax-free bonds are usually issued by a government enterprise to raise funds for a particular purpose and the interest is fully exempted from tax. Eg: NHAI, PFC, NABARD etc. Target maturity funds track fixed income indices and invest in a basket of securities. These indices mature at a predefined date and the fund will automatically credit the money back to your account post maturity. The returns will be closer to the Net YTM (i.e. Yield – Expense Ratio) that was prevalent the time of investment provided we remain invested until maturity.

Unlike tax-free bonds, target maturity funds do not offer any tax advantage. Similar to other debt fund categories, the short term gains i.e. gains realized within 3 years of investment are taxed as per the tax slab of the investor and the long term gains i.e. gains realized after 3+ years are taxed at 20% post indexation.

While there is no special tax advantage, with RBI hiking interest rates, bond yields in general have risen in recent months. Due to this, the net YTM of the target maturity funds have become attractive and currently range between 6.6-7.3%. Assuming inflation of 4-6%, the post-tax returns could be in the range of 6.1-7.0%.

Meanwhile, the yields of the tax-free bonds remain low and currently offer only around 5%. Therefore, target maturity funds with high credit quality exposure maybe a better option at the current juncture. Further, in case of sudden need for funds, target maturity fund investors have the option to redeem their investments from the AMC before maturity. However, tax-free bonds have relatively low liquidity as they can only be sold in the secondary market to another investor.

Similar to other debt fund categories, the short term gains i.e. gains realized within 3 years of investment are taxed as per the tax slab of the investor and the long term gains i.e. gains realized after 3+ years are taxed at 20% post indexation. Tax Free Bonds: No tax on interest received. Short Term Capital Gains in less than 1 year are taxed as per the tax slab of the investor and Long Term Gains realized after 1 year are taxed at 10% (there is no benefit of indexation).

Expert 5: Nidhi Manchanda, Certified Financial Planner, Head of Training, Research & Development at Fintoo

The increase in market yields because of the rise in policy rates has made it a propitious time to invest in the fixed-income markets to benefit from the higher yields. It is probable to note that interest rates may not rise further aggressively and over a tenure of long-term, interest rates will marginalize. As interest rates and yields start easing, bond prices will start inching up, and will result in potential capital gains to bondholders and debt mutual fund investors.

In the current rising interest rate scenario, even if the interest rates go up further their magnitude pace will be relatively lower. It is an appropriate time to make good use of the current scenario and take up this opportunity. The deal can be better if you, as an investor, are willing to lock in your funds for the foreseeable future, and here is where Target Maturity Funds come into picture.

Target Maturity Funds invest in government securities, PSU bonds, SDLs and high quality papers. It is suggested to invest in TMFs as they have a predefined maturity. Suppose, an investor invests in a TMF maturing in 10 years at 7.35% yield, investors will relatively get close to the same yield of 7.35% before expenses and taxes. Please note that a TMF, if held for more than 3 years are taxed at 20% with the benefit of indexation making it attractive for investors in higher tax brackets as compared to tax-free bonds where yields in the same maturity are in the range of 4.5%-5.5%. Also, the expenses of TMFs are comparatively lower as they are passively managed.

Talking about risk involved, Target Maturity Funds that invest in Government securities will be better as compared to Tax free Bonds issued by PSUs. Investors willing to take the opportunity of current elevated interest rates and invest for the medium to long term can choose to invest in Target Maturity Funds. Investors should further make sure to opt for those funds with the maturity aligning to their financial goals. Additionally, investors looking to invest in a staggered manner can choose to invest in TMFs of different maturities.

Expert 6: Utkarsh Sinha managing director Bexley advisors a boutique investment bank firm

There are certain tax advantages to being in target maturity fund over time, that when coupled with the higher expected return, can offset the tax advantages of tax-free bonds with lower coupons. However: as with any investment decision, this should not be a question of comparison, but one of composition. What are the goals you have with your portfolio, what is the maturity period of your planned need and how much risk appetite you have should all weigh in on the portfolio construction, where indeed both TMF and Tax Free Bonds may be valuable components.

The views and recommendations made above are those of individual analysts or broking companies, and not of Mint.

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