What are Target Maturity Funds? Advantages & Disadvantages

What are Target Maturity Funds – Advantages & Disadvantages

Updated on 16 Oct, 2023

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What are Target Maturity Funds?

Target Maturity Funds (TMF) are index-tracking debt funds that invest in bonds. Target maturity funds assist investors in navigating the risks associated with debt funds. These funds align their portfolios with the fund’s maturity date. TMF portfolios are composed of bonds included in the underlying bond index and have maturities close to the fund’s maturity. The bonds are held to maturity, and all interest income earned during that time period is reinvested in the fund.

Thus, target maturity bond funds, like FMPs, operate in an accrual method. Unlike FMPs, however, TMFs are open-ended and are available as target maturity debt index funds or target maturity bond exchange-traded funds. As a result, TMFs are more liquid than FMPs.

TMFs have a homogeneous portfolio in terms of duration. To elaborate, these funds invest in bonds that mature around the same time and align with the fund’s maturity. The fund’s duration decreases over time by holding the bonds to maturity. Thus, investors are less susceptible to price volatility caused by interest rate changes.

TMFs invest only in government securities, PSU debt, and SDLs (State Development Loans). As a result, they have a smaller default risk than other debt funds.
Due to the open-ended nature of these funds, investors have the option of withdrawing their investments anytime. Thus, in the event of any bad developments involving the bond issuers, such as a default or a credit downgrade, you can easily exit the fund.
It is ideal for holding target maturity funds to maturity despite being liquid. Holding them to maturity will help you predict the potential returns from the scheme.

Explore: Best Target Maturity Mutual Funds to Invest in 2024

Benefits of Investing in Target Maturity Funds

Following are the benefits of investing in target mutual funds:

Open-ended Funds: Target maturity funds are open ended mutual funds. You can redeem your investments anytime. Thus, the schemes are liquid, and you can easily exit the scheme. However, it is advisable to consider the capital gains impact while exiting the funds.
Flexibility: Target maturity funds are flexible and offer a range of tenures with the goal of identifying investments that offer good yields at any particular period in time. The structure of these funds is to reduce residual maturity. It means that as time passes, the maturity of the underlying bonds continues to decrease. Thus, duration risk continues to decline. Moreover, it becomes easy to predict returns from the fund.
Interest Rate Movements: Since target maturity funds invest largely in debt securities until maturity, their returns are insulated from the impact of rising interest rates. These funds are less prone to interest rate risk than standard bond funds. Since TMFs keep their bonds to maturity, this is less problematic in a rising interest rate environment. Otherwise, it can devalue an investment (unless you sell before maturity).
Tax Efficiency: Target maturity funds offer predictable and stable returns. In addition to this, they are also more tax-efficient than traditional instruments. Target MFs are taxable at 20% after indexation when the holding period is more than three years. When the holding period is less than three years, the short-term capital gains add to the taxable income and are taxable as per the slab rates.

Disadvantages of Investing in Target Maturity Funds

Following are the disadvantages of investing in target mutual funds:

No Track Record: The major drawback of target funds is the lack of actual performance history and track record. Furthermore, if you do not hold the fund to maturity, interest rate swings will significantly impact your investment.
Tracking Error: Tracking error is the difference between actual and benchmark returns. A high tracking error indicates a greater degree of divergence between the fund’s returns and the benchmark’s returns. A lower tracking error suggests that the benchmark and the fund are closely related. Generally, funds with lower tracking are preferable since the return will be more.
Early Exits: Target maturity funds are open-ended funds. Thus, investors can withdraw their investments at any time. However, if investors sell their investments prior to maturity, the investment may be subject to interest rate risk. Thus, lowering the returns.

How do Target Maturity Funds Work?

As per SEBI guidelines, a target maturity fund can invest only in Government securities (G-secs), State Development Loans (SDLs) and PSU bonds replicating the underlying bond index. Government securities enjoy sovereign status, SDLs enjoy quasi-sovereign status, and PSUs also enjoy sovereign status because the Government owns PSUs. Therefore, these funds have a superlative credit quality.

The TMFs hold bonds in their portfolio till maturity and roll it down as the years pass. Rolling down maturity means the duration or maturity of the bond portfolio reduces over time. For instance, a year after purchasing a 5-year PSU bond, the maturity will roll down to a 4-year bond and so on. This momentum helps to reduce the interest rate risk of the bonds in the fund portfolio. At the same time, it offers optimum yield or return on investment, making these funds a suitable investment option for investors with low-risk tolerance. Moreover, these bonds tend to perform better when the interest rates or yields are high and are expected to come down in future.

The bonds in the TMF portfolio pay regular interest (coupons) and principal on maturity. The coupons paid are reinvested in the fund, giving investors the benefit of compounding.

Who Should Invest in Target MaturityFunds?

Target maturity funds are suitable for investors who are looking for predictable returns. These funds are suitable for medium to long-term goals. Thus, investors with a similar investment horizon can consider investing in the target funds.

It is necessary to ensure that your investment horizon is similar to the fund’s duration since an early exit may yield lower returns. Early exits lower your returns, as the investments are prone to interest-rate risks. In other words, when the interest rates rise, bond prices fall, so the net asset value of the fund also falls.

TMFs are good for diversifying your investment portfolio. Moreover, since they offer stable and predictable returns, investors need not worry about market volatility. Therefore, if you are an investor seeking stable returns over a medium to long-term investment horizon, you can consider investing in target funds.

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