In today’s rising interest rate scenario, debt funds are likely to generate negative or minimal returns in the near term. However, the current rise in bond yields led by rising interest rate expectations has brought opportunities also for investors to lock in higher interest rates/yields.
We believe at this juncture, investors should classify their debt investments in two parts –
(a) liquid funds/bank fixed deposits for short term needs up to 3 years and
(b) target maturity debt funds for goals beyond 3 years.
By doing so, investors can be sure that they will earn around 4 – 5 per cent return for their investments in liquid funds/bank fixed deposits. On the other hand, they can expect a return of 6% – 7.5% from target maturity funds in medium to long-duration investments. Since the cycle of an interest rate rise has just started, investors may consider investing through the STP/SIP strategy in target maturity debt funds to they can benefit from a further interest rate rise. Whilst we all know about liquid funds and bank fixed deposits, the awareness is not very great for target maturity debt funds. Read below to explore target maturity debt funds:
1. What are target maturity debt funds?
These funds are passively managed debt funds with a defined maturity and predictable return trajectory. Akin to fixed maturity plans (FMPs), these funds follow a roll-down strategy but in this case in an open-ended structure. Roll down simply means that a fund manager will construct a portfolio of securities with a defined maturity and allow the maturity to fall in line with the fund’s tenure. Target maturity debt funds are meant for investors who are willing to stay invested till the fund’s maturity.
These funds predominantly invest in government securities (G-secs), treasury bills (T-bills), state development loans (SDLs) and AAA-rated corporate bonds, which entail a high degree of safety.
Did you ever think about investing in a quality bond and holding it till maturity? Target Maturity Debt funds do the same for you in a tax-efficient way.
2. What is the current Debt market scenario?
At present repo rate, at which the RBI lends short-term funds to banks has been raised by 40 bps to 4.40%. In a recent interview RBI governor, Mr Shaktikanta Das said that future actions of the Monetary Policy Committee will be dependent on inflation projections. The Reserve Bank of India is committed to containing inflation while keeping growth in mind. Monetary policy tightening by systemically important global central banks, especially the US Fed, will also put some pressure to further tighten policy rates here in India. This, in turn, will push domestic bond yields upward from current levels in the near term.
3. How does a change in interest rate affect bond yields and investor return?
A bond yield is an anticipated return an investor earns on that bond if s/he holds the bond till maturity. However, if an investor withdraws his/her investments before maturity, s/he will also earn either capital gain or loss depending upon how interest rates have changed from the date of investment.
The price investors are willing to pay for a bond can be significantly affected due to changes in interest rates during the holding period. If current interest rates are higher than the interest rate that was prevailing at the time of investment in bonds, then the investor would experience a fall in bond prices.
That’s because new bonds are likely to be issued with higher coupon rates as interest rates have increased, making the old or outstanding bonds generally less attractive unless they can be purchased at a lower price. So, higher interest rates mean lower prices for existing bonds and capital loss for the existing bond investor.
E.g. Let’s say you buy a corporate bond with a coupon rate of 7% and 10 years to maturity. While you own the bond, the interest rate rises to 8% and then falls to 6%.
a. When the interest rate is the same as the bond’s coupon rate. The price of the bond is 100, meaning that buyers are willing to pay you the full Rs. 100 for your bond.
b. When the interest rates rise to 8%. Buyers can get around 8% on new bonds, so they’ll only be willing to buy your bond at a discount. In this example, the price drops to Rs. 93. At 93, the yield to maturity of this bond will match the prevailing interest rate of 8%.
c. When the interest rate drops to 6%. Buyers can only get 6% on new bonds, so they will be willing to pay extra for your bond because it pays higher interest. In this example, the price rises to Rs. 107. At 107, the yield to maturity of this bond will match the prevailing interest rate of 6%.
Other factors like the financial health of the issuer, type of bond and inflation expectations are also considered while deciding the price of the bond.
4. Why Target Maturity Debt Funds are the right choice in the current scenario?
Target maturity funds have risen in popularity recently because of the style consistency the category offers — a guarantee that the fund will stick to the quality criteria specified in the benchmark index and predictable maturity & return as stated.
From the portfolio management perspective, in a normal debt fund, the fund manager takes an active call in maintaining the portfolio maturity profile within the ranges defined by SEBI. E.g. A short duration debt fund can maintain its portfolio maturity within the range of 1 – 3 years. Whereas medium duration funds invest in securities with a maturity profile of 3 to 5 years. Whereas a Target Maturity debt fund invests in securities which match its defined maturity date and holds the securities till maturity.
From the risk management perspective, normal debt funds i.e. short term / medium term / long term debt funds will continue to maintain the same risk profile throughout the holding period as their portfolio duration range is defined. However, in target maturity debt funds, funds risk profile continues getting lower as their portfolio duration will continue getting lower with time. We find target maturity funds more practical as investors’ risk continues reducing as they approach their financial goals.
5. What should be the investor’s mindset for investing in Target Maturity Debt Funds?
Before investing in these Target Maturity Debt funds, investors should be clear about the financial goals for which they are investing in these funds, so they can choose the fund with a goal-matching maturity profile. Further, they should invest with the mindset of holding their investments till the defined maturity date of the fund portfolio to avoid a scenario of capital loss, in the case of a rise in interest rates in the interim.
