Investing in target maturity funds

It is interesting how most people tend to put investment products into certain buckets and then paint all solutions with the same brush. For example, you would assume that all equity products are risky while all debt products are low risk. However, the interesting thing is that this is not always the case. There are some equity funds that are relatively lower risk than others while there are debt products that are relatively higher risk than others. The reason why you need to know this distinction is that when you know the risk then you are in a better position to deal with it. When it comes to investing in debt instruments, there are two main risks that you need to think about. One is interest rate risk, i.e., impact on the price and returns of your fixed income investment due to changes in interest rates default risk, i.e., the probability that the principal and interest payments on your fixed income investments are not made completely. A great way to deal with the risks in debt instruments is to invest in target maturity funds.

What are target maturity funds?

Target maturity funds are passive debt funds that track an underlying bond index. This means that the portfolio of target maturity funds comprises bonds that are part of the underlying bond index. More importantly, the maturity of the bonds in the underlying index is close to the target or stated maturity of the fund. The bonds in the target maturity fund are held to maturity, i.e., to the end of their tenure and all the interest payments received on the bonds are reinvested in the fund. An important thing to remember is that the duration of the portfolio of all the bonds in the portfolio is more or less the same and all the bonds mature at more or less the same time. The duration of a bond measures how sensitive is the price of a bond in response to changes in interest rates. Thus, when the bonds in the portfolio are held to maturity, the duration of the fund keeps falling with time. As a result, investors are less prone to price fluctuations caused by interest rate changes.

Advantages of investing in target maturity funds

There are some distinct advantages of investing in target maturity funds. Some of these include:

• Mitigate interest rate risk: If you choose to stay invested in a target maturity debt fund till its maturity then you can expect returns similar to what were mentioned at the time you invested in the fund (yield at the time of investment). While there will be periodic price fluctuation, you will get the expected returns on maturity. As a result, the impact of interest rates on your investments gets mitigated.
• Mitigate default risk: Currently, target maturity funds are mandated to invest in government securities, PSU bonds, and State Development Loans (SDLs). Due to the credibility of the issuer, these funds tend to have lower default risk compared to funds that comprise bonds from other issuers. Further, since these are open ended funds, investors can easily choose to withdraw/exit the investment in case of any adverse developments that could potentially lead to a default or credit downgrade.
• Liquidity: Since target maturity funds are open-ended and available as index funds or ETFs, they are highly liquid and can easily be traded. Another important thing to note is that they offer a great deal of flexibility as they are available across maturities.

While target maturity funds indeed have a great deal of advantages, you should be aware that these advantages can only be reaped if you hold the investment in the fund till maturity. If you are looking to stay invested for a fixed period of time and require stable and known returns, then you should consider investing in a target maturity fund.

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