Target maturity funds have triggered interest in the present rising rate scenario. But many of you appear confused between this category of funds and constant maturity funds. We hope to provide some clarity on this, with this article.
What is a target maturity fund?
Target maturity funds are open-ended passive debt funds with a fixed date of maturity. Because they are open ended, they can be bought and sold like your normal open-ended funds as they have no lock in. These funds can be in the form of ETFs, Fund of funds (that invest in the ETF with the same maturity) or index funds. These funds define three things when they are launched:
- The index that the fund will follow/mimic
- The nature of instruments they will invest in. Presently, they are predominantly either government securities (G-Secs) PSU bonds and state development loans (SDLs) or a combination of these.
- The maturity of the fund.
The underlying instruments will be bought and held till maturity. This does not mean the instruments won’t change. The underlying papers may be bought more (to deploy inflows) or sold (to meet redemption). It is sufficient that the fund maintains the residual maturity and the nature of papers (or nearest to it) defined in the benchmark.
If it is an ETF, it will be traded on the exchange to provide you with an exit, when you want, before the maturity date. Otherwise, you can buy and sell them like any other fund.
Some of the important characteristics of these funds are as follows:
- As these are passive debt funds, they have a very low expense ratio. The expense ratio ranges from 0.05% (more for ETFs) to 0.16%. This is significantly lower than active debt funds.
- Equate this category of funds to FMPs, except that they are liquid, unlike FMPs.
- These funds can come with varying maturities. The present crop of about 43 ETFs and funds have target maturities ranging from 2023 to 2032. The residual maturity reduces as you near the target date. For example, the maturity for someone who entered Bharat Bond fund 2023 in the year 2020 would be 3 years then. But if you were to enter now, it would be less than a year. So, whether the fund holding is long term or short term for you would depend on the fund’s residual maturity. You need to therefore align your own time frame with the fund’s maturity.
- These funds will be taxed like debt funds, enjoying capital gain indexation benefit if held for over 3 years.
- Since these funds follow a hold-till-maturity strategy, the yield of the fund at the time of your investment will roughly be your returns, if you also hold the fund till its maturity. If you plan to hold these funds till maturity, then the timing of your entry becomes very important. The data below will show you how yields have moved up in these funds (with over a year’s track record). That means you would have been better off entering this year than last year.
Please note that debt fund taxation has undergone a change. Indexation benefit will not be available for investments made from April 1, 2023 onwards. You can read about this in our article, ‘Tax changes in mutual funds: How to manage your investments now‘.
Constant maturity funds
These are funds that will have to maintain a steady residual maturity at all times. In this SEBI-defined category, these are G-secs with a constant maturity of 10 years. That simply means that the average maturity (note that it is average; not every instrument needs to have 10-year maturity) of the fund’s portfolio shall be maintained at 10 years at all times. What does this mean?
- This category of funds DOES NOT mature in 10 years. They are open-ended and will be run with 10-year maturity at all times.
- The maturity of the fund will not reduce as years go by. They remain at 10 years. That means the fund has to sell or buy G-Secs to ensure that the maturity is maintained.
- The fund manager does not have much leeway to take duration calls – that is to reduce or increase maturity of the fund, like gilt funds or dynamic bond funds do.
- Their expense ratios are marginally lower than long term active debt funds (and similar to gilt funds) but higher than target maturity funds. As they don’t have a buy and hold strategy, they need more monitoring than target maturity funds.
So, in one way, this is an active fund that is somewhat passively managed, in the debt space. We often say that your timeframe should be aligned to the time frame of the fund. So, does that mean that you need a minimum of 10-years to invest in this fund? Not really. Over 1-year periods, these funds can deliver negative returns. Over 3-year periods, they have not. Yet, in a low to flat interest rate scenario, they can deliver returns as low as 4% even over 3-year periods. This is why we advocate a minimum holding of 5 years for these funds (our Prime portfolios carry these funds for only over 7-year periods).
Target maturity vs constant maturity
Let us try and make the distinction between these two categories of funds in the following manner:
#1 Maturity
Target maturity has a fixed maturity post which the fund closes while a constant maturity fund will remain open at all times. This is an important distinction you need to understand. So, you cannot continue to hold a target maturity fund beyond the maturity and you will have to switch to some other investment. To this extent, there is a reinvestment risk (risk of rate uncertainty when it matures) in this product, like an FD. But that is not a great deterrent as you can always switch to open-ended active debt funds or other target maturity funds then.
#2 Your time frame
With constant maturity funds, you necessarily need to have a longer term of 5 years or more if you decide to enter it. It is best done through SIPs as a 5-year period can see a rising rate scenario (when the fund will fall) as well as a falling rate period (when fund will gain). Lumpsums are fine when we are nearing rate peaks. With target maturity funds, you need to choose funds that match your own maturity (assuming you hold these funds till maturity). For example, a 2023 maturing fund will work for the very short term while the 2027 or 2028 maturing funds work for medium to long term.
#3 Yield and returns
With target maturity funds, the yield at the time of your entry will largely decide your returns, if you hold them till maturity. With constant maturity funds, the yield at which you enter does matter, since it decides whether you are entering at rates peak or a low rate. But the returns could be more or less than such a yield depending on the rate cycles and the period of your holding. This is so because, in addition to the interest accrual, there could be capital appreciation or capital depreciation on the fund, based on whether the fund is additionally gaining (when rates fall, prices gain) or losing (when rates move up).
But with target maturity, if you hold them till maturity, then such capital appreciation or depreciation will not exist. However, if you sell them before maturity, you could see such gain (higher returns than yield) or see lower returns than yield or loss at times (depending on the cycle). That means you should know when to exit, if you intend to do so ahead of maturity, in the case of target maturity funds.
This means your return expectations from target maturity funds (if held fully) should be roughly the yield. With constant maturity funds with over 5-year holdings, this can vary a lot, depending on rate scenarios. So, there is higher uncertainty in constant maturity funds than target maturity funds.
#4 Volatility
Depending on whether the target maturity fund has a lower maturity (when you enter) or higher maturity, it can be low or high on volatility and can give negative returns as well. For example, the 2031 maturing Bharat Bond has a marginal loss (-0.5%) in the past 1 year, whereas the 2023 maturing fund from the same AMC has a 3.5% return over the same period. In the case of constant maturity funds, as a debt class, they can be highly volatile over 1–3-year periods, especially in a rising rate scenario. The one-year return of these funds is presently -2.8%!
Which should you go for?
Constant maturity funds as an asset class have limited track record (they changed their avatar from other categories after SEBI categorization in 2018) and target maturity funds have an even shorter record. So, it is not possible for us to give you performance statistics comparing them.
Which one you choose needs to be based on your timeframe, return expectation, and what you’re looking for. If you need certainty in returns and are investing for a fixed time, then the current rate scenario makes target maturity funds an interesting proposition. We have a call on target maturity funds here.
Constant maturity funds work if your timeframe is long or not strictly defined, you do not mind volatility, you aim for higher returns (without credit risk) or you simply want debt allocation in your long-term equity-heavy portfolio. These funds also work well if you plan to invest through SIPs for the long term. We have a recent call on this as well here.
Target maturity funds help you pick up specific, good return opportunities. Constant maturity funds are fit very well for debt allocations. There is absolutely no harm in mixing both in your portfolio, by taking a ladder strategy (a mix of low, medium and longer duration funds). SIPs are fine in both types – but bear in mind that SIPs work better only when the fund’s duration is longer (as volatility will be higher in such cases). For short to medium term target maturity funds, it is better to lock into yields with lumpsum investments.
