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Fixed income: Target maturity fund is a smart bet

If investors want higher predictability of returns and have a longer time horizon, target maturity fund is better as compared with actively managed short-term bond fund

The bonds in the portfolio are held to maturity and all the interest payments are reinvested in the fund.
The bonds in the portfolio are held to maturity and all the interest payments are reinvested in the fund.

With low returns from various fixed income products, conservative investors are increasingly investing in open-ended target maturity funds for predictable returns with liquidity. These passive debt funds align their portfolios with the maturity date of the fund and track an underlying bond index. The bonds in the portfolio are held to maturity and all the interest payments are reinvested in the fund.

As target maturity funds invest in government securities, bonds of public sector companies and state development loans, the default risk is lower as compared with other debt funds. The duration of the fund keeps falling with time and as a result less prone to price volatility due to interest rate changes. These funds will help investors to plan their investments for a period of five years.

Why target maturity funds now?
Target maturity debt funds are suitable for individual investors in two ways. R Sivakumar, head, Fixed Income, Axis Mutual Fund, says if the investment horizon matches with the target date, these funds behave similar to fixed maturity plans (FMP). Unlike an FMP, target maturity funds offer liquidity. “At the same time, the duration rolls down over time. Thus the volatility tends to reduce as the fund gets closer to the target maturity. Investors who are targeting specific segments of the yield curve are able to invest in these funds without being locked in till maturity,” he says.

Interest rates in India and globally are expected to move up as CPI inflation in advanced economies is above the 5%-level. While the Reserve Bank of India has maintained an accommodative monetary policy stance in its February policy, it is expected to hike rates gradually. The markets have factored in rate hikes and the yield curve up to five years is steep, with one-year G-sec rates at 4.70 and 5-year rates at 6.35 levels.

Murthy Nagarajan, head, Fixed Income, Tata Mutual Fund, says higher returns in target maturity funds and indexation benefits should give 5.5% to 6% tax-free returns to investors. “Given the geopolitical uncertainty and other asset class expected returns, investors can make target maturity funds part of their portfolio,” he says, adding that if investors want higher predictability of returns and have a longer time horizon, they would be better off in target maturity funds compared to actively managed short-term bond funds.

Associated risks
While credit risk is low, investors must factor in the interest rate risk before investing in target maturity funds. Rajeev Radhakrishnan, CIO, Fixed Income, SBI Mutual Fund, says investors should consider the interest rate risks inherent in an open-ended fund in a potentially rising rate environment if their holding period is not aligned with the targeted maturity of the fund.

“The funds have to invest in a defined list of issuances which may not be optimal from yield perspective and there could be yield impact arising from ongoing flows and the deployment of the same in issuances matching the index,” he says. Radhakrishnan suggests that fixed maturity plans with clearly defined rating matrix may be superior from the yield perspective over similar tenors if ongoing liquidity is not a requirement.

Investing in a rising rate scenario
In a rising rate scenario, short-term investors should match their investment horizon with the duration of the fund. It is preferable to have shorter duration so that this reinvestment effect dominates over the volatility induced by rising rates. Sivakumar says over a longer horizon, say three years or more, this is less relevant as interest rate cycles in India tend to be relatively short. “Thus, over a period of time the volatility impact of rising rates is tempered. Longer-term investors should try to find funds that match their risk profile— that is, with duration and credit quality that are aligned with their needs,” he says.

Targeted plays
Unlike a fixed maturity plan, target maturity funds offer liquidity
Higher returns in target maturity funds and indexation benefits should give 5.5-6% tax-free returns to investors
Target maturity funds are best for situations where the investment horizon matches the target date
Investors must factor in the interest rate risk before investing in these funds
In a rising rate scenario, go for shorter duration target maturity funds

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