Should you invest in target maturity funds?
PremiumTMFs have been investing in government-backed bonds or public sector undertaking bonds with AAA ratings
Target Maturity Funds (TMFs) are the open-ended index funds that passively invest in the bonds of an underlying index with a defined fixed maturity. TMFs predominantly invest in government securities, public sector undertakings (PSU) bonds, and state development loans (SDLs) and the instruments are held until the maturity of the scheme. TMFs provide some degree of return predictability for those who stay invested until the maturity of the scheme. For example, BHARAT Bond ETF - April 2030, launched in December 2019 invests in AAA-rated public sector bonds instruments in the Nifty BHARAT Bond Index-April 2030 and has a current yield to maturity (YTM) of 6.9%. That means, an investor investing in the fund now, if held till maturity, may earn a return of 6.9% per annum. This is before deducting the expense ratio of 0.0005%.
Right time to invest?
There seems to be more investor interest for TMFs vis-à-vis all the other available debt MF categories for long term investment, according to Nitin Shanbhag, head, investment products, Motilal Oswal Private Wealth.
Many TMFs with medium- to long-term maturity have come up in the last one year and a few more are filed with SEBI to be launched soon. The idea is that as the difference between short-term and long-term interest rate increases, a TMF provides an opportunity for investors to earn a higher post-tax return on long-tenure fixed instruments if held till maturity. In India, the yield on long tenure – a 10-year government security has spiked from 5.8% in mid-2020 to almost 6.7% now.
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“In India, the bond market, to a large extent, has priced in the rise in interest rates by RBI going ahead. Approximately 4-6 year tenure is considered a sweet spot currently, among the multiple maturity brackets available. For those bonds with tenure beyond that, the uptick in the yield from one tenure to next is not high enough," said Joydeep Sen, an independent debt market analyst. This explains why most of the TMFs being launched by the mutual funds lately are designed to mature between 2025 and 2027. The other big differentiating factor for TMFs when compared to traditional fixed income instruments like fixed deposits is the favourable tax treatment.
When invested for over 3 years, these are taxed at 20% after indexation. If held for less than 3 years, the short-term capital gains are taxed at slab rates of the individual. On the other hand, returns from traditional fixed-income investments irrespective of the period of holding are taxed at slab rates of the individual. Thus, these instruments are more tax-efficient for those in the higher tax bracket if held for more than 3 years. As TMFs are open-ended and provide liquidity, these are also in a way replacing fixed maturity plans – a fixed tenure mutual fund – just like TMFs but are close-ended schemes.
Risks of investing in TMFs
For debt funds, the two primary risks are credit risk and interest rate risk. All the current target maturity funds have been investing in either government-backed bonds or PSU bonds with AAA ratings. Thus, the credit risk is low. The interest rate risk – fluctuation in bond prices with change in interest rates in the economy – will also be mitigated, when the investment is held till maturity.
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In the Potential Risk Class (PRC) matrix disclosed for all debt mutual funds, the interest rate risk for the target maturity funds points towards moderate to high risk. This is because, if the investments in these funds are withdrawn before maturity, there is a risk of mark to market losses. “From a disclosure perspective, there is no surety that an investor would stay till the maturity date. On the back of the volatility that comes with duration, the risk disclosure will be on the higher side," said Devang Shah, co-head, fixed income, Axis Mutual Fund. Investors also run the risk of relatively low returns if yields move significantly higher from here, and investors could, therefore, regret locking into lower yields, said Dhawan. “Besides, if inflation spikes significantly on the back of high oil prices and supply-demand mismatches, investors could get negative real returns even if they hold to maturity," Dhawan added.
Who should invest?
Experts say that one should invest in these funds only if the investment horizon matches the maturity of the scheme. Investors who have financial goals that match the tenure of these funds and want slightly better returns than fixed deposits with better tax efficiencies should consider investing in TMFs, said Abhilash Joseph, business head, Finity.
Shanbhag from Motilal Oswal Private Wealth suggested a barbell approach while investing in TMFs for optimum returns. He said, “We suggest a barbell approach using Target Maturity Funds, i.e., 65-70% allocation to 3-5 year maturity funds (currently yielding 5.75-6.00% p.a.), and the balance to be allocated to 10-year maturity funds (currently yielding 7.00-7.10% ). This would ensure an optimum combination of overall portfolio yield and duration."
“Investors could consider investing between 25 and 35% of their fixed-income allocations to this category if they do not need liquidity. Investors could consider schemes maturating 2026/2027 or 2031/2032 depending on their holding period capacities and laddering needs of investing in a manner where different schemes mature at different periods in time to mitigate reinvestment risk," said Dhawan.
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