Target Maturity Funds (TMF) have suddenly attained popularity amidst a reasonably chaotic macro environment. In the year 2021 alone, there were over 10 -12 TMFs launched. Here we understand the nuances of these target maturity debt funds, this will help you assess if these funds are ideal for you. 

What are target maturity funds?

TMFs are open-ended debt funds which have a specific maturity date, they are also called target maturity bond funds. They are similar to fixed maturity plans (FMPs) in the nature in which they operate. However, FMPs are closed-ended funds, while these are open-ended schemes. These funds invest in bonds that form a part of the respective indices required to emulate and outperform. They invest in high-quality bonds issued by PSUs, SDUs, other Government led units and other corporates with good credibility. The underlying bonds of TMFs are mostly AAA bonds. Hence the chance of default risk is quite low, thereby indicating that the risk appetite of target maturity bond funds is low.

There are variants within the TMFs based on the benchmark that they are stacked against; for example, a target maturity debt index fund is expected to track a debt index fund, and target maturity ETF (exchange-traded funds) are traded on the exchange and tend to have more liquidity. 

How do target maturity funds work?

Target maturity debt funds are passively managed funds which have a maturity period; upon maturity, the principal and the interest are paid to the investor. The underlying portfolio of the target maturity debt index fund would mirror the benchmark indices such as the Nifty SDL or Nifty PSU bond index. The bonds held by the fund are also a part of the index and have the same maturity dates. They are held till maturity.

For example, the SBI CPSE bond plus SDL fund was launched in Jan2022 with maturity in September 2026 50:50 Index. The target maturity debt index fund emulates the underlying assets of the index. Upon maturity of the bonds in the indices, the bonds underlying the fund also mature.

In case there is a change in the underlying index’s maturity, the target maturity debt index fund’s maturity will also change. The investors will be notified about the change in the maturity of the bonds. On maturity, the units of the scheme will be automatically sold at the prevalent NAV as of the maturity date. 

Benefits of investing in TMFs

Here are the advantages of adding TMFs to your portfolio:

  1. Open-ended:
    These are open-ended schemes, which essentially means that you can enter and exit the fund at your discretion. You need to keep in mind the tax implication that arises from the redemption of the fund. 
  2. Tax efficiency:
    This is one of the key benefits of TMFs and other debt mutual funds as against conventional debt instruments. TMFs held for a period of greater than 3 years would be assessed under capital gains; for long-term capital gains tax, the benefit of indexation is extended. Indexation is adjusting for inflation, which results in inflating the purchase price, thus lowering the tax liability.
  3. Low Credit Risk:
    As these funds invest in government securities and AAA rated papers that mirrors benchmark, there is minimal or no risk of default. Also, unlike FMP, portfolio of the fund can be viewed in the factsheet of the fund.
  4. Diversified portfolio:
    The bonds held by the funds offer varied interest rates, and the maturity period is spread over time. This offers the benefit of minimising risk; the returns are optimal as well. The risk is lowered not only due to the diversified portfolio but also because they are held till maturity. The mark-to-market effect which occurs due to the interest rate changes periodically is not reflected in the TMFs if held till maturity.

Disadvantages of target maturity funds

There are some downsides to investing in target maturity debt funds; here they are:

  1. New phenomenon:
    This investing class is relatively new compared to other similar funds such as bond funds, there is no historical data to establish that investing in them will be beneficial as compared to investing in regular debt mutual funds or conventional debt instruments. 
  2. Early exit risk:
    As this is an open-ended fund, it offers the benefit of an early exit. However, this could be counterintuitive. Here’s how, if you are holding a TMF with maturity in 2026 but choose to exit the fund before maturity. In the event that the interest rate trend increases, then the bond prices of the bonds held in the fund are likely to fall.

    This is because investors now prefer new bonds being issued at higher interest rates as against the bonds held by the TMF, which offers lower interest rates. There could be a selling pressure to meet your redemption request, and the holding of the fund would be sold at a loss.

    On the contrary, in case the interest rates are decreasing due to the rate cut by RBI, the bond prices of the bonds held under the fund start to rise; if you choose to exit early, you will fail to gain the benefit of this uptrend. 

Target maturity debt funds: Who is this best suited for?

These funds are ideal for investors who prefer return predictability for a given period, it has gained popularity among conservative investors in recent times. They are directly comparable to the fixed deposit type of return. Although returns are not guaranteed, there is a certain degree of predictability attached to the returns from these funds. The taxability aspect also remains attractive when compared to fixed deposits. The underlying assets are of optimal credit quality.

However, it is imperative to note that, like in the case of equity, you also need to strategically manage your debt investments. These funds provide optimal returns only when the interest rates are at a peak or upward trending. This will allow the investor to lock in the high yield over the tenure of the fund.

Investing in these funds does not make sense when the interest rates are trending downwards and are nearly close to the trough. Hence, choose to invest in these funds based on your risk appetite and, more importantly, on the interest rate cycle. In order to opt for the best target maturity bond funds, it requires a deep understanding of debt markets to be able to strategically optimize returns from the debt market investments.

In a nutshell

While this investment is novel and attractive, it should be timed right to help you optimize your portfolio returns. Depending on your comfort level and risk appetite, it is a great addition as a debt option to your existing portfolio. You can reach out to experts at TATA Capital who can help you decide on the best target maturity bond funds for your portfolio and your financial goals.

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