TMFs are a relatively new category of funds and are gaining investor interest. Target Maturity Funds (TMFs) are essentially debt mutual funds that invest in fixed-income securities. While being open-ended (they can accept new investments), they have a definite end date or closure date, which is disclosed at the fund’s launch.
TMFs launched thus far are linked to an index, and the fund managers have a mandate to invest in a manner that closely replicates the underlying index. Given that these funds have a definite closure date, they tend to invest in instruments that mature on or close to the closure date.
They are also subject to some regulatory restrictions in terms of what instruments they can invest in and so on.
The current array of available TMFs has invested mostly in Government Securities or securities issued by government entities. As a result, the nature of the underlying holdings ensures that these funds have limited credit risk since we can assume that the government will not default on its obligations.
Like all debt funds, TMFs have a daily pricing mechanism that acts as the basis for investors’ purchase or redemption of units. This also allows investors to track the value of their investments, if they so desire, daily.
Interestingly, being index funds by nature, they tend to have a lower expense ratio and, thereby, be more beneficial over the long run.
Are index funds within debt funds a new concept?
Investors tend to associate index funds with equity funds. Indexing applied to debt funds is a relatively newer concept in India.
The debt segment is not widely known on market indices; hence, TMFs that are launched are usually introduced with custom indexes.
These indices are constructed to meet the requirements of a specific fund and will include components in line with the strategy of the fund house. The existing array of TMFs has a high leaning towards instruments issued and backed by Central Government, State Government and Public Sector Enterprises.
What makes TMFs unique?
These funds’ characteristics and operational aspects make them attractive from multiple perspectives
- Safety of Capital: Since the vast majority of TMFs invest in Central Government Securities, State Development Loans and Debt Instruments of PSUs, there is an implied degree of safety that is quasi-sovereign
- Predictability of Returns: Given that these funds have a regular disclosure of portfolio Yield To Maturity and Expense Ratio, investors who invest in these funds with an intention to hold to maturity have a clear picture of returns that can be expected.
- Tax Treatment: Since these are debt funds and have a growth option, the fund’s returns can be reinvested in the fund, and the gain at the end of the investment period will be subject to capital gains. If the gains are long-term, they enjoy the benefit of indexation and a favourable tax slab.
- Liquidity: From an investor’s perspective, these funds can be redeemed at any time of the investor’s choosing.
- Ease of Transaction: Investors may invest and redeem through tech platforms or through their investment advisors.
- Returns: Having a Fund structure combined with the Held to Maturity nature of the holdings gives them a cost advantage. TMFs invest in government securities, including state government loans which tend to have some level of illiquidity premiums attached. These factors combine to ensure that the returns on TMFs are marginally better than regular funds and deposits.
What should you bear in mind when investing in TMFs?
We recommend that investors take an FD-like approach to investing in MFs. Regarding TMFs, we recommend that investments be made only when the time horizon exceeds three years.
We also recommend that investors invest with a clear understanding of the prevailing Yield To Maturity (YTM) and the Expense Ratio of the specific fund.
The combination of these two factors will provide some guidance on the prospective returns if held till the maturity date.
Investors must note that these funds are subject to interest rate changes. The sensitivity of the fund NAVs will be a factor of the fund’s duration. A higher-duration fund will tend to have higher volatility. So investors must be prepared for scenarios where returns may be front-ended or back-ended.
The Scripbox recommended TMFs have holdings with minimal credit risk (possibility of default). However what needs to be understood is that there can be scenarios where minimal risk may actually manifest as realized risk. As an investment advisor, we will continue to monitor recommended funds and raise flags when appropriate.
What are the Downsides to Investing in TMFs?
- Volatility – Investors who have a mindset of looking at price movements on a daily basis may find the volatility of TMFs to be higher than they are comfortable with.
- Choppy Returns – The expected returns may not come in as smoothly as expected, and if there is a change in interest rates, the returns may be front-ended or back-ended depending on the move of interest rates.
- Reinvestment Risk – The fixed maturity date means that the amount that is received on maturity of the funds will need to be re-invested and available alternatives then should be reviewed, and decisions should be taken.