Target Maturity Funds Decoded

Within the universe of debt mutual funds there are a variety of options available to investors. The nature and behaviour of each category of debt funds is heavily dependent on the tenure of individual securities held within the fund. Variants of debt funds such as liquid funds, ultra short term bond funds, corporate bond funds and gilt funds are well known to investors. But there is another category of debt funds which are relatively lesser known and therefore not clearly understood by investors in India. These are target maturity debt funds.

Target maturity debt funds invest in a set of bonds which mature on a certain date in the future and therefore both the fund and the bonds within them mature on the same date. It effectively becomes a closed ended fund with characteristics of an open ended fund. In other words a target maturity debt fund is wound up on a specific date in the future like a closed ended fund. But until the date of winding up, investors can freely buy and sell units of the fund in the same way as an open ended fund.

But how exactly does a target maturity debt fund work? And how can investors employ them in their financial plans effectively? All this and more will be answered today.

Fundamental Mechanics And Risks

The first thing to understand about target maturity debt funds is that they are a passive mode of investment in debt mutual funds. Therefore they are likely to carry lower costs relative to other categories of debt funds. They are usually sold either as an index fund or an ETF. But it is important to note that most debt ETFs in India offer poor liquidity. It is therefore prudent for investors to prefer target maturity funds that are offered as traditional index funds.

There are two major risks associated with debt mutual funds of any sort. These are credit risk and interest rate risk. Target maturity debt funds usually invest in various types of government securities such as government bonds, PSU Bonds and State Development Loans (SDLs). These instruments usually enjoy a sovereign credit rating, especially in the case of government bonds. When a debt instrument enjoys a sovereign credit rating, it means that there is negligible risk of such instruments defaulting on interest payments or repayments of principal.

Target maturity debt funds therefore manage credit risk effectively. And because target maturity debt funds hold securities which have maturities similar to the maturity of the fund itself, the average maturity of the fund keeps reducing. Such a progressive reduction in the maturity of the fund would make it less sensitive to interest rate changes over time, provided the bonds in the portfolio of the fund are not sold or frequently traded by the manager of the fund. And because a target maturity fund is essentially a debt index fund, the chances of bonds being sold or traded frequently during the tenure of the fund are relatively low. Therefore target maturity funds also manage interest rate risk effectively.

Returns

All target maturity funds would have an indicative measure of return known as the Yield To Maturity (YTM) of the fund. This is return an investor in a target maturity fund can reasonably expect if they were to hold the fund from the date of inception through to the date of maturity. So if the investor were to hold fund right from the NFO period (when the fund is first alloted) through to the date of maturity, the return would be largely similar to the fund's YTM. But if not, the returns would vary. Variability in returns would also be seen if the bonds in the portfolio of the fund were to be sold or traded during the tenure of the fund. It is important to note that the investor's actual return is likely to be slightly lower than the fund's return due to the impact of expense ratios.

Taxation And Reinvestment Risk

Target maturity funds allow investors to defer the point of taxation until actual redemption. But they must remember that target maturity funds are essentially debt funds. Gains from such funds would therefore be taxed at slab rates applicable to the investor. It is also important to remember that the bonds within a target maturity fund typically pay interest semi annually. The fund manager must reinvest the interest at prevailing interest rates. There may be situations where prevailing rates are lower than the original YTM of the fund. This leaves such funds vulnerable to a degree of reinvestment risk.

To Invest Or Not To Invest?

If we have a goal that falls due after a certain number of years, a target fund with a maturity that matches the due date of our goal can be one of the options for the debt component of the portfolio for such a goal. For example, a target maturity fund which winds up in 5 years can be considered as an option for the debt portfolio of a 5 year goal. Those who wish to invest in target maturity funds must therefore understand them clearly before acting upon any plans of investing in them. Though target maturity debt funds are essentially debt index funds which in theory makes them a relatively low risk investment option, there still are some risks that are unique to such funds. Also, the suitability of such funds for our financial goals would mainly depend upon the tenure of the fund matching the investment horizon of our goals. This means that the decision to invest in such funds must only be made in complete cognisance of all these facts.