Why target maturity funds should be in your portfolio as interest rate increases slow

The rise in policy rates and the resultant increase in market yields has made it an opportune time to invest in the fixed income markets to benefit from the higher yields and any potential capital gains that arise as the cycles reverses.

Bond yields and prices move in opposite direction. Hence, when bond yields rise, bond prices decline. As interest rate and yields start easing, bond prices will start inching up, resulting in potential capital gains to bond holders and debt mutual fund investors.

Can the rates go higher?

This is a valid question that you as an investor should consider before investing in a fixed income fund.

For the near term, though it cannot be said with certainty, but given the recent trends in the macro-economy, it is likely that interest rates could only go up marginally from here. We may not be at the peak of the rate cycle yet, but it is quite likely that we are close. In the longer term, interest rates in the economy should gradually head lower.

There are also certain cues that we can take from interest rate movements in developed economies.

Let us look at the US Fed rates movement since the turn of the millennium. In the mid-2000s, the Federal Funds Rate peaked at 6.5% before starting to gradually come down. In 2007, it peaked at 5.25%. If we go farther in the past, in the late 1980s, the rate peaked at 9.75%.

Broadly, with economic growth, the peak interest rate even in an upcycle has come down. Not necessary that this is replicated across economies, but it is quite likely to happen as economic growth accelerates in India.

Present interest rate, future benefits

In the current interest rate cycle in India, though, as highlighted earlier, even if the interest rates go up further up, the magnitude pace will probably be low. At present, we can objectively deduce that this is an appropriate time to make good use of the opportunity that the current elevated level of interest rates has presented. The deal can be sweeter if you, as an investor, are willing to lock in your funds for the foreseeable future.

This is where Target Maturity Funds (TMFs) come into picture. These debt funds present an opportunity to invest in debt markets, with a reasonable degree of predictability of returns.

The only condition is remaining invested throughout the duration of the fund. Having said that, remaining invested throughout is not mandatory and you have an exit option available in case a need arises.

A TMF is a debt fund that tracks a fixed income benchmark having a predefined maturity. The maturity of the scheme coincides with the maturity of the underlying index. Moreover, the fact that TMFs predominantly invest in securities with the highest credit rating brings down the credit risk of these funds significantly.

Consider this. Today, you invest in a TMF that matures in December 2025, having a current Yield to Maturity (YTM) of 7.35%. If you stay the course, your annualized returns are likely to be in the close vicinity of 7.35%, before expenses and taxes. The indexation benefit that kicks in after three years of investment in a debt mutual fund ensures that the returns that you earn from these funds are tax-efficient.

The passive nature of the schemes translates into a relatively low expense ratio.

Positioning investments with goals

Schemes like TMFs are best suited if you have an investment horizon in line with the maturity of the fund.

Moreover, the relatively lower level of risk in these schemes (if you remain invested till maturity) means these are suitable for financial goals where not just visibility of returns but even preservation of capital is crucial. These factors make TMFs a worthy addition to financial portfolios for goals like retirement or children’s higher education.

If you are worried about the near-term volatility and rise in interest rates, you can stagger your investments over the next few months. Further, you can also look at distributing your investment amount across TMFs having different maturities if you do not need the entire investment in one go. For instance, an investor can opt for TMFs spread over a few years if the end goal is funding education where the fee payment, and hence liquidating the investment, will be needed in tranches.

Other than asset allocation based on risk tolerance, taking advantage of an evolved situation can aid in strengthening the financial plan for an investor. The psychological sense of triumph when the reward kicks in is a bonus.

(The author is Deputy Managing Director and Chief Business Officer at SBI Mutual Fund)