Target Maturity Funds (TMF)
InCred Wealth December 6, 2022
In the last 12 months, bond markets have exhibited heightened volatility and delivered subdued returns, as the global and domestic monetary conditions have tightened (through a combination of aggressive rate hikes and withdrawal of easy liquidity). Bond yields have risen more than 200bps in CY22 and fixed income investors are in pursuit of stability and predictability of returns in their fixed income portfolio.
While traditional investment avenues like Fixed Deposits offer stable returns, they do not readjust with the changing interest rate scenarios on a real time basis. Target Maturity Funds (TMFs) can be a good fit for investors in the current rising interest rate scenario as these funds are giving investors the opportunity to invest at current market yields. Further, if the investor stays invested till the maturity of the fund, it mitigates the risk associated with change in interest rates cycle. TMF offer better liquidity profile, minimal credit risk and superior tax-adjusted returns.
What are TMFs?
TMFs are an open-ended passive debt scheme that aims to replicate the composition of predefined fixed income index and have a fixed maturity date. By holding the bonds to maturity, the duration of the fund keeps falling with time and hence investors are less prone to price fluctuations caused by interest rate changes. All interest payments (of the underlying bonds) received during the holding period are reinvested in the fund. Thus, TMFs operate in an accrual mode like FMPs (Fixed Maturity Plans) and mature on the redemption date.
TMFs are currently mandated to invest in Government Securities, PSU bonds, and SDLs (State Development Loans) thereby carrying lower default risk compared to other debt funds. Target maturity funds can be either Exchange Traded Funds, Index Funds or Fund of Funds (FoF).
Advantages of TMF:
- Liquidity / No Lock-in: TMF are open-ended funds (unlike FMPs), which means investor have the option to invest or exit anytime during the tenure of the fund. Even the underlying bond holdings of the fund are highly liquid.
- High credit quality / Low default risk: TMF predominantly invest in Gilt/SDLs/AAA PSU Bonds. These bonds are sovereign / quasi-sovereign in nature hence the credit quality is very high.
- Mitigates interest rate risk:If investors hold it till maturity, the interest rate risk is mitigated. TMF follow a roll down approach i.e., average maturity of the scheme’s portfolio reduces with the passage of time.
- Relatively Stable & Visible Returns:TMF works like an FMP (defined maturity) in an open- ended architecture. Investors have the options to choose from varied tenure of TMF aligning with their investment time frame.
- Tax efficient:Investment >3yrs holding period qualify for 20% LTCG with indexation benefit.
- Reduce non-systematic risk: Reduction in non-systematic risk like security selection and portfolio manager selection, as the fund will apply buy & hold strategy and follow the index.
- Low Cost: Being a passive Index Fund / ETF / FoF, with a high credit quality portfolio, the expense ratio is relatively lower compared to actively managed debt funds.
TMF are suitable for risk-averse investors seeking predictability and stability of returns (akin to FDs / FMPs) in their fixed income allocation. This category can be a core allocation of the fixed income portfolio.
We prefer 4yr to 6yr residual tenure TMFs, which offers better carry adjusted for duration, as the yield curve is flattish (5/10yr term spread <20bps).
TMF offers superior tax-adjusted returns:
As seen from the below table, the post-tax returns of TMFs are higher compared to traditional investments like fixed deposits.