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Why target maturity funds are attractive even at low interest rates

The success of the Bharat Bond ETFs showed that investors are comfortable investing in these top-rated/ government-backed funds

December 23, 2021 / 10:53 AM IST

Target maturity funds have risen in popularity recently because of the style consistency the category offers — a guarantee that the fund will stick to the quality criteria specified in the benchmark index and predictable maturity as stated.

Also, the fall in interest rates has dampened the charm of deposits, and while debt mutual funds have emerged as able alternatives, the volatility in returns inhibits their attractiveness.

In this context, let us take a close look at target maturity funds and what endears them to investors.

Understanding target maturity funds

These are passively managed funds with, as the name suggests, a target date to mature.

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Globally, these funds invest in multiple asset classes including equity and are primarily used in long-term financial planning, especially retirement, with a glide path from risky to safe assets as they near maturity dates.

In India, however, the current crop of target maturity funds invests only in the debt market.

These funds follow a simple methodology at present. The fund house decides a benchmark index to mirror basis its analysis of yield, risk and strategy, and then creates an investment portfolio of the investor’s money basis the underlying allocation of the portfolio/ index.

So, how are these different from the erstwhile fixed maturity plans (FMPs), which were popular and had a similar premise of investing in securities for the duration of the fund and strategy? The answer lies in their structure, which provides ease of liquidity to investors.

FMPs are closed-ended funds and, despite being listed on stock exchanges, are scarcely traded, thus restricting liquidity. However, target maturity funds are open-ended offered either through ETFs or index funds and their units can be bought or sold any time after their launch and before their maturity.

Reasons for their rising popularity

Several factors are at work here including success of the Bharat Bond ETF series, though not the first in the target maturity funds space, showed that investors are comfortable investing in these top-rated/ government-backed funds.

AMCs have launched a flurry of these funds; of the 23 funds launched in the debt space in 2021 till October, as many as 8 are target maturity funds. This has pushed the assets of the category to ~Rs 50,000 crore as of October 2021 — nearly four times the ~Rs 12,000 crore mark at the end of December 2019 — increasing their share of open-ended debt funds to 3.4 percent from 1 percent over the period.

Currently, these funds predominantly invest in government securities (G-secs), treasury bills (T-bills), state development loans (SDLs) and AAA-rated corporate bonds, which entail a high degree of safety. The safe play is in line with the investor sentiment in recent years, following a number of credit and liquidity events that have roiled the debt market.

The investment opportunity

Target maturity funds offer investors an opportunity to invest in government securities and top-rated papers, and thereby lock their money at the prevalent yields, thus providing some predictability in returns. Investors tend to benefit in such roll-down maturity (also called held-to-maturity or HTM) portfolios when interest rates are higher, thus boosting the return.

The current funds in the market have been structured to ride the yield curve, with most of the maturity dates in the 3-5 year bucket, which has seen steepness of curve compared with the 1-3 year maturity bucket. In simple words, it is beneficial that in present times, instead of investing in debt funds that come with an average duration of 1-3 years, target-maturity funds that come with 3-5 year maturity dates are beneficial on account of the yield spreads.

The steepness of the 5-year PSU AAA and SDL categories compared with 2-year peers is 1.20 percent-1.57 percent currently, compared with ~0.50 percent two years back.

Meanwhile, after falling from a high of ~6.70 percent pre-pandemic to ~5.70 percent post-lockdown, yield on the 10-year G-sec has risen again to trade around 6.36 percent and is expected to climb further to 6.50 percent by March 2022.

Meanwhile, CRISIL expects the Reserve Bank of India (RBI) to withdraw liquidity in the banking system in a calibrated manner as more certain signs of economic recovery become visible. The expectation, though, is predicated on growth staying on track. As growth strengthens, demand-side pressures on inflation are likely to start rising, leading the RBI to raise the repo rate by 25 basis points towards fiscal 2022-end. Monetary policy tightening by systemically important global central banks, especially the US Fed, will also exert some pressure to tighten policy rates here in India. This, in turn, will push domestic yields upward from current levels.

Going forward, therefore, elevated interest rates will provide investors an opportunity to lock in their investments.

The final word

To reiterate, the current funds in the market have been structured to ride the yield curve, with most of the maturity dates in the 3-5 years bucket, where the curve has steepened, thus locking in the ‘sweet spots’ through duration mapping.

The investment horizon of more than three years also benefits investors in terms of post-tax returns investors due to indexation benefits.

That said, investors need to note that rising interest rates and the impact of fresh flows in the category on potential returns are all-too-real risks. Also, the liquidity of the funds—in terms of both, ingress and egress—impacts the overall yield of the portfolio and thus could dilute yield for existing investors.
Piyush Gupta is Director, Funds Research at CRISIL
first published: Dec 23, 2021 10:53 am
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