Target Maturity Funds: Suitable Avenue for your Fixed Income Portfolio?

October 11, 2021 Mutual Fund

Passively managed equity-oriented mutual funds have gained a lot of traction with investors in the last couple of years. Similarly, in case of debt mutual funds, passive funds such as Target Maturity Funds are slowly emerging as the preferred choice among investors.

Over the last few months, various mutual fund houses such as IDFC MF, Edelweiss MF, Aditya Birla SL MF, Nippon MF, ICICI Pru MF, and Axis MF have launched Target Maturity Funds. Many more such funds are expected to be rolled out in the coming months.

What are Target Maturity Funds?

These are open-ended debt mutual funds that invest in securities in line with that of the underlying bond index and with similar maturity profile. For instance, Axis AAA Bond Plus SDL ETF – 2026 aims to track the Nifty AAA Bond Plus SDL Apr 2026 50:50 Index, while IDFC Gilt 2027 Index Fund endeavours to mirror the performance of CRISIL Gilt 2027 index.

Target Maturity Funds are launched either through the ETF, Index Fund, or Fund of Fund route. Having a demat account is mandatory to invest in a Target Maturity ETF.

[Read: ETF v/s Index Fund: Which is the Better Passive Investment Option?]

Target Maturity Funds generally hold the securities until maturity. On the day of maturity, the scheme will distribute the maturity proceeds to the investors.

The following are the advantages of investing in Target Maturity Funds:

1) Low credit risk

Target Maturity Funds predominantly invest in government securities, and state development loans (SDLs) that are backed by sovereign guarantee, as well as AAA rated corporate/PSU bonds, in line with the benchmark index. Therefore, from the credit quality perspective, these funds are relatively safe. The low credit risk makes Target Maturity Funds suitable for investors with a low-risk profile.

2) Predictable returns

Target Maturity Funds hold securities till maturity, i.e. they follow a buy-and-hold investment strategy. Therefore, the impact of mark-to-market loss on these funds is low. If you hold Target Maturity Funds till maturity, your returns will be in line with the portfolio’s current yield to maturity (YTM).

For instance, the indicative return for the recently launched IDFC Gilt 2027 Index Fund is 5.88%. Moreover, since passive funds track a particular index, you get an idea about the portfolio composition of the scheme. This gives investors an idea about the returns expectation.

3) Advantage over FMPs

Target Maturity Funds are similar to Fixed Maturity Plans (FMPs). FMPs are close-ended debt funds but lack liquidity even though they are listed on exchanges, which makes it difficult for investors to exit. Unlike FMPs, Target Maturity Funds are open-ended in nature and highly liquid. Investors can purchase or redeem units in Target Maturity Funds at any time.

4) Ease of goal planning

With Target Maturity Funds, you can select schemes that have a maturity in alignment with your investment horizon. Mutual Fund houses have launched Target Maturity Funds with varying maturities such as those maturing after 3 years, 5 years, 7 years, and so on. This coupled with predictable yield to maturity makes Target Maturity Funds suitable for planning financial goals at a low risk.

5) Taxation benefit

Target Maturity Funds are taxable similar to other debt mutual funds. Investors in the highest tax bracket can benefit from indexation if they invest for 3 years or more. In this case, gains are taxable at 20% with indexation benefits. Gains on short term investments (less than 3 years) are taxable as per your income tax slab.

What are the risks associated with Target Maturity Funds?

As mentioned earlier, investing in Target Maturity Funds enables you to lower the impact of interest rate volatility if held till maturity. However, if you redeem your holding before the maturity date, your returns may be lower, depending on the prevailing market conditions. Therefore, consider investing in Target Maturity Funds if you can hold investments until maturity.

Another disadvantage is that since interest rates are at a multi-year low, your investment in Target Maturity Funds will get locked in at the current rate. Therefore, you would potentially earn lower returns than if you lock-in returns when the interest rates are high. That said, if you need to address a financial goal, you should not delay making the investment/s.

Furthermore, as these are passive funds, some Target Maturity Funds may have higher tracking errors. In this case, your returns can vary significantly from the underlying index.

Should you invest in Target Maturity Funds?

Interest rates are currently at a multi-year low with the expectation of rise in inflation. It is expected the interest rates will start to head upwards in the near future. However, when it will happen is not clear. In the current uncertain interest rate environment, it is advisable to invest in debt funds where the maturity of the portfolio matches with your investment horizon.

Investors with moderate to low risk profiles can consider Target Maturity Funds of varying maturity for their medium to long term goals. Target Maturity Funds can offer you the benefit of low-cost investment that carries low credit risk. It can also mitigate the impact of interest rate volatility, provided you hold your investment till its maturity.

If you do not have long term horizon, invest in shorter maturity debt funds such as Liquid funds, Short duration funds, Banking & PSU debt funds, etc. to safeguard against interest rate risk.

This article first appeared on PersonalFN here