Investors can lock into current high yields with target maturity funds

The medium- to high-maturity variety of these funds can also offer capital gains if interest rates fall

Interest rates, which are currently at or near peak levels, are expected to head south in the second half of 2024. Investors can use target maturity funds (TMFs) to lock into current attractive yields or make capital gains.

“We expect central banks to start easing from mid-2024. This could be a good time to lock in yields by investing in TMFs,” says Kaustubh Gupta, co-head of fixed income, Aditya Birla Sun Life Asset Management Company (AMC).

Arun Kumar, vice-president and head of research, FundsIndia, concurs. “Debt fund returns improve when interest rates fall and vice-versa. TMFs maturing in more than five years can be a good idea if you expect interest rates to come down,” he says.

How do TMFs work?

TMFs are bond funds that have a clearly-defined maturity date. They typically track a bond index, which comprises central government, state government, high-quality public-sector unit (PSU) bonds, and AAA-rated corporate bonds.

The fund manager’s portfolio mimics the index. The bonds purchased are held till maturity. Interest earned on them is also reinvested in bonds with similar maturities as those present in the index.

A TMF can have a residual maturity ranging from a few months to as long as 10 years.

Low credit risk, predictable returns

These funds offer several benefits: low expense ratio, no fund manager risk, and almost zero credit risk. “Since almost all TMFs have government securities (G-Secs), state development loans (SDLs) and AAA bonds only, so credit and liquidity risks are minimal. Interest-rate risk can also be eliminated if a TMF is held till maturity,” says Gupta.

TMFs can offer predictable returns. “Their returns will be close to the net yield-to-maturity (net YTM is YTM minus expense ratio) at the time of investment if you stay invested until maturity,” says Kumar.

Why invest now?

Interest rates are at or near peak levels currently. TMFs can help investors lock into current bond yields. They also have the potential to offer capital gains.  

“TMFs will provide returns closer to entry-level yields (portfolio carry) if held till maturity. Medium- to long-duration TMFs provide additional return potential through capital appreciation if you remain invested during a period of falling interest rates and redeem thereafter,” says Amit Tripathi, chief investment officer, fixed-income investments, Nippon India Mutual Fund. TMFs offer assured liquidity near net asset value (NAV).

TMFs versus FDs

Fixed deposits (FDs) of large commercial banks maturing in one to three years are offering interest rates of around 7 per cent.

The longer-dated TMFs are currently offering slightly higher net yields.  

TMFs offer the benefit of liquidity. “Being open-ended, you can enter and exit TMFs at any time, which provides flexibility in managing your money. If you have an emergency and need money, you can withdraw from most TMFs without any penalty. In case of FDs, you need to keep your money till maturity, or else you are paid a lower interest rate and also have to pay a penalty for premature withdrawal,” says Gupta.

TMFs also offer the possibility of earning capital gains. “TMFs with higher duration can deliver higher returns than FDs in a falling interest rate environment,” says Kumar.

Both gains from TMFs and interest income from FDs are taxed at slab rate.

Which TMF to pick?

Investors should ideally invest in TMFs that mature in line with their holding period. For example, if one wants to invest for a three-year time frame, one should invest in a TMF that matures in three years.

“If an investor is simply trying to capture the carry offered in a particular index, then it has to be held to maturity.

However, if the investor is using these products for a specific end purpose (to increase duration for a temporary phase, alter the overall portfolio’s credit risk profile, etc.), then the tenure of these investments should match the extent of these requirements,” says Tripathi.

Investors with a higher risk appetite can invest in a longer-dated TMF and sell after they have earned capital gains, if interest rates come down. However, this approach exposes the investor to interest-rate risk.