scorecardresearchTarget Maturity Funds: Should you invest in them during current interest rate scenario?

Target Maturity Funds: Should you invest in them during current interest rate scenario?

Updated: 27 Aug 2022, 04:43 PM IST
Unlike open ended debt funds of other categories, target maturity funds help in locking the portfolio yield for a fixed period of duration without any significant volatility, if held till the maturity.
Target Maturity Funds

Target Maturity Funds

After ultra-loose monetary policy across the world post the pandemic, the central banks are on interest rate tightening spree post the inflation crossing all roofs. India is also not left behind and the inflation beyond the comfort level of RBI forced the central bank to raise the repo rate thrice raising it effectively from 4% at the start of May’22 to 5.4% in Aug’22, a total hike of 140 bps. RBI shifted its focus from an accommodative stance of promoting growth to taming inflation including promoting growth which is still not out of wounds.

The interest rate hikes hurt the fixed income portfolio the most as interest rates are inversely related to bond prices. As we speak, the market expectation of aggressive rate hikes has ebbed which is quite reflecting from 2 yr OIS (Overnight Index Swap) which has started showing signs of peaking out and has fallen from its recent peak of 7% in mid of Jun’22 to 6.13% in mid of Aug’22.

So, the question arises – what should an investor do in this scenario when interest rates are still headed up moderately, if not aggressively?

Debt Funds which comprise interest rate and credit risk, if built properly can be a boon to debt allocation of portfolio. Apart from actively managed funds (where the fund manager changes the duration of portfolio as per the prevailing interest rate scenario) to fixed duration funds (here the fund manager maintains a fixed maturity) which may not work always, Roll Down Funds work the best as it helps investors in locking the yield, if held for the said maturity.

What are roll down funds?

Roll Down Funds are not new; rather they are an improvised version of Fixed Maturity Plans (FMPs). FMPs, where the yield and maturity are locked in, Roll-Down Funds are open ended FMPs with a fixed maturity and yield and the portfolio duration of the portfolio is allowed to diminish as time progresses. Some AMCs have positioned their open ended debt funds into a roll down strategy so as to minimise the interest rate risk as the maturity drops with the passage of time.

Now there is one more innovation over and above the roll down strategy as there is always a risk that the fund manager may not roll down the fund the way it’s envisaged as it is the discretion of the fund manager. The new innovation is Target Maturity Funds, an open ended debt fund, more prominent now and almost all AMCs are lining up or already floated the debt funds in this category targeting the different maturity on the yield curve.

Target Maturity Funds removes the fund manager biasness and targets a particular year of maturity and generates the return as envisaged in the form of YTM (minus expenses) at the start of product tenure. This may not be close to 100% of yield expectation as new inflows down the targeted years may distort the ytm to some extent. However, the locked-in yield is more or less certain.

Why target maturity funds? Which tenure to choose?

As said, unlike open ended debt funds of other categories, target maturity funds help in locking the portfolio yield for a fixed period of duration without any significant volatility, if held till the maturity. Also, as the time progresses, the interest rate risk subsides which further reduces the volatility in the portfolio.

The steep yield (upward sloping) provides an interesting opportunity – it makes sense to invest into 4-6 yearsof maturity as yields post 4-6 yearsdon't provide any significant yield spread relative to 10 yearsand above. 5-years point offers sufficient carry to interest rate hikes.

Also, the yield spread between 5 years G-Sec and 5 years-AAA is very narrow at present unlike the high historical average. Hence, it makes sense to stick to target maturity funds having either of 100% in G-Sec which may include SDLs (State Govt Loans which are typically priced 50 bps higher than G-Secs and are also sovereign in nature and guaranteed by state govts; hence, carry no credit risks) or mix of AAA and G-sec (including SDLs). At present, the 5 years segment has been trading at 7%+ ytm which post expenses comes down to 6.5-7%.

Another reason why one should look into 3+ years maturity is the indexation benefit in taxation which is applicable only if the investments are held beyond 3 yrs.

First mover advantage

Edelweiss MF had first mover advantage in this category when they launched a series of Bharat Bond ETFs / FoFs targeting different maturity of yield curves. Later on, as the category picked up prominence, most AMCs started launching target maturity funds having different maturity, the most prominent ones are 2026 / 2027 / 2028. AMCs also started experimenting with 100% G-Secs or 100% SDLs or a mix of 50% each in AAA and G-Secs/SDLs offering a platter of choices to investors.

What benefits do target maturity funds draw?

  1. No interest rate risk if investments are held till maturity
  2. Visibility of returns over the said investment horizon
  3. Credit risk is low as most of the securities invested are into G-Secs / SDLs / AAA
  4. Over 3 years of maturity, one enjoys indexation vs traditional FDs which are taxed marginally
  5. Easy liquidity unlike FMPs where the investments are locked in till maturity
  6. Low-cost offering, an effective way to build debt assets

So, in the current interest rate scenario where most rate hikes are priced in or we may see another 1-2 small rate hikes, Target Maturity Funds provide an excellent opportunity to lock in the yield without compromising much on credit risk and interest rate risk. One may spread over the investments over the next 6 months via STPs or funds having different maturity to average out the locked-in yield if the interest rate moves up further.

For whom are these suitable?

Fixed income investors having 3 years plus investment horizon can consider these funds. Since there are a plethora of maturities to choose from, one may target the fund whose maturity profile matches one’s investment horizon. This helps in containing the intermittent interest rate risk to a large extent. Technically, at present, 5 years or 2027 maturity fund makes sense.

Amar Ranu is the Head - Investment Products & Advisory at Anand Rathi Share & Stock Brokers Limited

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First Published: 27 Aug 2022, 04:43 PM IST