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As rates harden, are target maturity funds better than regular debt schemes?

Target maturity schemes typically track the underlying index and buy bonds specified in that index that mature on or before a given date

March 01, 2022 / 12:51 PM IST

Many fund houses are focusing on target maturity schemes that invest in high-quality bonds and mature over four to six years. The response from investors has been good. But does that mean existing open-ended debt funds are of little use? Let’s understand how they stack up against each other.

Duration versus Maturity

Typically, target maturity funds help you plan your investments for about 3-4-year time periods; even a five-year period at times. For such goals, they aren’t your only options. Mutual funds also offer medium duration funds (schemes with a duration of 3-4 years) and medium to long duration funds (schemes with a duration of 4-7 years). The question is: which is better?

Target maturity schemes (TMS) focus on the maturity of bonds. They typically track the underlying index and buy bonds specified in that index that mature on or before a given date.

While the open-ended funds maintain a duration at the defined level, target maturity funds’ residual maturity goes down over a period of time. This means that over a period of time the interest rate risk goes down in case of TMS.

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“Target maturity schemes invest in bonds in line with asset allocation defined at the inception of the scheme, which ensures that investors get some visibility of returns and duration risk,” says Amit Bivalkar, Managing Director and CEO, Sapient Wealth Advisors & Brokers. It can be an investment option for those conservative investors whose investment timeframe matches with the maturity of the target maturity scheme, he adds.

In the case of an actively managed open-ended debt fund, the fund manager is bound by duration of the overall portfolio of the scheme and not maturity of individual bonds. So there can be investments in long tenured bonds as well as money market instruments, which may have more or less susceptibility to the changes in interest rates. Fund manager can take a view on bond market and may move the duration and portfolio constituents accordingly to take advantage of some short term opportunities.

“Within the permissible limits for the scheme the fund manager of an actively managed debt fund tries to generate alpha by changing the duration of the scheme. This is done considering the fund manager’s understanding of global and local macro-economic factors, available opportunities in the debt market and what is the chance of the opportunity playing out,” says Kaustubh Gupta, Co-Head of Fixed Income, Aditya Birla Sun Life AMC.

Credit risk

Most TMS invest in bonds issued by public sector undertakings, government securities and state development loans (SDL). Since most of the corporate bonds with AAA ratings are quoting at very low yield, the fund houses are now focusing on government bonds offering relatively better yields. “Since most TMS are investing in high quality bonds, the credit risk is low. And as the asset allocation clearly dictates tracking indices comprising high quality bonds in stipulated proportion, there is little scope for slippage, making these an attractive investment for conservative investors,” says Joydeep Sen, Corporate Trainer-Debt. In open ended actively managed debt fund the fund manager can invest in bonds of any credit rating, as the mandates for duration based debt products do not put any restriction on the type of credit risk they can be allowed to take, he adds.

Tgt Mat Scheme 0103_001

According to Value Research as on January 31, 2022, 15 percent of the assets under management of medium duration funds was invested in AA rated bonds. Investors must remember that many TMS are also medium duration funds which do not invest in AA and lower rated bonds. Hence the average number looks small. Actively managed debt funds invest in bonds with ratings AA and below. For example, Axis Strategic Bond fund has 32 percent money invested in AA rated paper. Aditya Birla Sun Life Medium Term Plan (46 percent) and ICICI Prudential Medium Term Bond Fund (55 percent) exposure to AA rated bonds. While the AA or lower rated bonds bring in additional risk, they also offer some returns kicker. As long as investors are comfortable holding on to tad more risky portfolio, such exposures if well diversified may not hurt.

Expenses

Though active fund manager may work hard by managing duration and taking calculated credit risk, the expense ratio of the scheme can act as a big drag on the scheme’s returns. The expense ratio of the TMS are low –typically less than 35 basis points. Likes Bharat Bond ETF series charge much lower. Expense ratios of medium duration and medium to long duration actively managed schemes however, are no match. Some of these charge as high as 2 percent towards expenses. When the portfolio yield to maturity are hovering around 6 percent on an average, high expense ratio schemes are best avoided.

What should you do?

You should ideally match your investment timeframe with the maturity profile of the scheme. For conservative investors the TMS can be a good investment if they can remain invested till the maturity of the scheme. The rising interest rates will weigh on the movement of net asset value of the debt schemes – both TMS as well as traditional open-ended duration products. The quantum and pace of interest rate hike is difficult to predict now. Though Reserve Bank of India has signalled slower than expected rate hike cycle earlier, the crude oil going past $100 mark can make it reconsider its stance as inflation may hit hard. The US Fed on the other hand, may want to go slower than expected as the Russia Ukraine military action may impact the economic recovery.

“Though target maturity funds are suitable for investors with moderate to low risk profiles given the predictability of returns, the high possibility of interest rates rising cannot be ignored in medium term,” says Roshni Nayak, SEBI Registered Investment Advisor and Founder of Goalbridge, a Mumbai based financial planning firm. Instead of locking in money for five years or more in target maturity funds, investors can consider actively managed short duration funds as fund managers there are relatively better placed to tide over rising rates and accordingly churn their portfolios and play the duration, she adds.

Open-ended traditional debt funds may appeal to only those who believe in the fund manager’s ability in adding value by actively managing the bonds portfolio. But go with only those schemes with a track record and relatively lower expense ratio.
Nikhil Walavalkar
first published: Mar 1, 2022 09:03 am
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