Selecting a target maturity fund based on your horizon and risk appetite

Constitution of underlying indexes doesn't matter since all the three categories of bonds they invest in are safe

The assets under management (AUM) of target maturity funds (TMFs) have risen from Rs 29,601 crore in October 2020 to Rs 1,21,855 crore in October 2022. Fixed maturity plans (FMPs), which also allow investors to lock in existing interest rates, have seen a steep decline in AUM, from Rs 1,54,442 crore in October 2018 to Rs 15,250 crore in October 2022 (data source: Morningstar India).

“TMFs offer a fixed-income investment with a defined maturity date, high visibility of returns (there is no guarantee, but there is high visibility if the fund is held till maturity) and good credit quality portfolio. It is a simple, easy-to-understand product,” says Joydeep Sen, author and corporate trainer (debt).

What is on offer?

TMFs invest in an underlying index, which consists of bonds that mature slightly earlier, or on the same date as the TMF. So far, fund houses have constructed these indexes using government securities (G-Secs), state development loans (SDLs), and AAA-rated bonds of central public sector undertakings.

New fund inflows are used to purchase the bonds included in the index. The interest received on bonds in the portfolio is also redeployed in the same bonds.

High credit quality

The yield on the 10-year G-Sec has moved up from 5.87 per cent on November 20, 2020 to 7.30 per cent on November 25, 2022. Many investors wish to lock into the current higher yields.

TMFs invest in a public index, so investors know beforehand which instruments the fund will invest in. This makes them transparent. It is not possible for a fund manager to exercise any discretion regarding the inclusion of bonds in their portfolios.

In an FMP, the portfolio is not ready, so investors can’t view it. And fund managers can exercise discretion in portfolio construction.

Since the indexes consist of high-quality bonds, there is little credit risk. “TMFs invest in high quality debt–sovereign, corporate debt, or a combination of the two. Since instruments in this fund have a fixed maturity date, there is reasonable visibility of performance if held till maturity,” says Sirshendu Basu, head-products, IDFC Asset Management Company (AMC).

Investors also benefit from their low-cost nature. “These passively managed funds have an expense ratio in the range of 0.06 per cent to 0.5 per cent,” says Anup Bansal, chief business officer, Scripbox.

Interim volatility

TMFs are subject to interest-rate risk. The Reserve Bank of India (RBI) may continue to hike the repo rate, though experts say the end of the rate hike cycle is near.  

When interest rates rise, the bonds in the portfolio, especially the long-term ones, experience mark-to-market losses, which affects the fund NAV adversely. “These funds will experience volatility due to changes in the repo rate and liquidity within the system. Withdrawing before the fund maturity date can result in diminished returns. If held till maturity, there is no interest-rate risk,” says Bansal.

Investors are also subject to reinvestment risk. “The investor is faced with a reinvestment decision at maturity that could give rise to possible reinvestment risk,” says Basu.

Invest according to horizon

Conservative investors who don’t want to take credit risk and are keen to lock in rates will find these funds attractive.

On selecting the right TMF, Sen suggests: “Match your cash flow time horizon and the maturity of the TMF.”

The underlying indexes of these funds can consist of varied combinations of G-Secs, SDLs, and AAA PSU bonds. Since all the three categories of bonds are safe, you can go with any TMF whose maturity date matches your investment horizon.

The tax factor

Invest in a fund that has more than three years left to mature if you wish to enjoy tax-efficient returns. Capital gains booked on the units of a debt fund held for more than three years are considered to be long-term and are taxed at 20 per cent post-indexation. Investments of up to three years are taxed at slab rates. This makes investing in TMFs (for more than three years) attractive for investors in high tax brackets compared to fixed deposits, whose interest income is always taxed at slab rate.