Your debt-fund strategy now: Explore target-maturity funds

In our previous articles, we talked about the volatility in the debt market amid the ongoing pandemic. With a spike in bond yields since the start of this year, several debt funds delivered subdued or negative returns over the short term. The subdued returns have made investors cautious and left them wondering what their debt-fund strategy should be in the future.

In a bid to counter the risk of rising yields, the first few steps should be to avoid long-duration bonds and avoiding credit risk funds. Let's see another option that you can explore.

Hitting the target with target-maturity funds
Target-maturity funds are a relatively recent development in the debt markets. Given their style, they carry low interest-rate risks and hence can be useful for investors amidst a rising-rate scenario. These funds tend to follow a roll-down maturity portfolio.

Effectively, here the maturity period comes down over a period of time. So, the fund manager sets a maturity target at the outset and then resets it once the maturity slides down to zero. Since maturity rolls down over a period of time, the interest-rate risk also reduces.

Target-maturity funds can be looked at as a sort of successors of FMPs, where the fund manager buys and holds securities with maturities similar to the term of the fund. Therefore, in a five-year FMP, the fund manager would buy bonds with a maturity of five years.

Here are some advantages of target-maturity funds:

• Low costs: Given the ETF/index-fund structure of target-maturity funds, they have considerably low expense ratios. In the debt segment, since costs matter a lot, this is a big positive.
• Negligible credit risk: Most available target-maturity funds comprise government securities, state-development loans and bonds issued by PSUs. Given their high credit worthiness, the default risk is low in target-maturity funds. In the aftermath of credit blowups, target-maturity funds do offer the required safety to debt-fund investors.
• Predictability of returns: The USP of such funds is the predictability of their returns. If investors hold these funds till maturity, they can expect to earn the indicative yields. It is important, however, to note that no mutual funds guarantee returns. Currently, the indicative yields of target-maturity funds are in the range of 6-6.5 per cent. Most funds being launched under this category are targeting a five- to seven-year timeframe. This is mainly because, given the prevailing economic conditions, that seems to be the sweet spot.

In the current context, the yields on offer in target-maturity funds may look good but these funds make more sense when one is at the top of the high-rate cycles so as to lock in the higher yields and derive the benefits by staying put throughout. But as things stand today, we are not in that phase. Having said that, these funds do have a compelling case with respect to minimising the mark-to-market losses. More broadly, target-maturity funds offer a good opportunity for investors looking to minimise the duration risk by investing for a similar horizon as the duration of the fund.