Should you invest in Target Maturity Index Funds when interest rates are high

The CPI inflation in September 2022 spiked up to a 5 month high of 7.41%, despite 50 bps interest rate hike by the Reserve Bank of India (RBI) in August. Earlier this month, the US Federal Reserve hiked interest rates by another 75 bps and the RBI may follow suit in by raising interest rates again in their December Monetary Policy meetings. Interest rate changes have an inverse relationship with bond prices; bond prices go down when interest rate goes up and vice versa. Since longer duration bonds are more impacted by interest rate increases, longer duration debt funds can be volatile in the near term. What should long term debt investors do, in this interest rate scenario?

Bond Yields are attractive now

The chart below shows the yields of the Government Bonds of different maturities as on 31^st October 2022. You can see that yields in the 3 to 7 year maturity range are 7.3- 7.5%, which are quite attractive compared to the interest rates of traditional fixed income products of similar tenures. You can lock in these yields over the period till maturity by investing in Target Maturity Funds.

Source: Worldgovernmentbonds.com, India Government Bonds Yield Curve, as on 31^st October 2022. Disclaimer: Current yields can change depending on economic and market conditions

What are Target Maturity Index Funds?

Target maturity index funds are passive debt mutual fund schemes tracking an underlying index comprising of government securities and/or corporate bonds. These funds endeavour to replicate an index by investing in bonds forming part of the index and intend to provide returns corresponding to the total returns of the securities in the index. Unlike other open ended mutual fund schemes, target maturity funds have defined maturity dates. You can lock-in current yields over the respective maturity periods by investing in target maturity funds, provided your investment tenure matches with the maturity of the scheme.

How do Target Maturity Index Funds work?

• Target maturity index funds track an index investing in Government Securities (G-Secs), State Development Loans (SDLs), Corporate Bonds and Public Sector Undertaking (PSU) bonds.


• The bonds pay coupons (interest) at regular intervals and face value (principal) on maturity. The coupons paid by the bonds are re-invested as per the asset allocation of the target maturity fund.


• On maturity of the fund, the bonds will pay the face value and accrued interest (as applicable). The fund will pay the maturity proceeds to investors holding units of target maturity funds.

What is the interest rate risk in Target Maturity Index Funds?

Interest rate risk refers to change in bond prices due to interest rate changes. Though target maturity index funds are subject to interest rate risk, the interest rate risk decreases over the tenure of your investment. Target maturity funds roll down the maturities of their bonds. For example, if you buy a 5 year bond with the objective of holding it till maturity, after one year the 5 year bond will become a 4 year bond, after 2 years it will become a 3 year bond, so on so forth.

Interest rate risk is directly related to maturity of a bond e.g. 5 year bond will have higher interest rate risk compared to a 4 year bond. If you roll down the maturity, you continue to get same yield on your portfolio at which you had invested if you hold the Fund till maturity and your portfolio risk reduces with shortening maturity. This makes target maturity funds good investment options for investors especially in an environment when interest rates or yields are high, and are expected to come down in the future. You can lock-in the yields by investing in the fund at a higher yield and reap the benefits by holding the fund till maturity. If your investment tenure matches with the target maturity date of the fund, interest rate changes (up or down) will have no impact on your returns.

What is credit risk in Target Maturity Index Funds?

Credit risk is an important consideration when you invest in debt. As per SEBI’s mandate Target Maturity Funds can invest only in G-Secs, SDLs and Corporate Bonds including PSU bonds. G-Secs have sovereign guarantee. SDLs have implicit sovereign status because RBI guarantees interest and principal re-payment of SDLs. PSU bonds also enjoy quasi sovereign status because the majority ownership of PSUs is with the Government. Target Maturity Funds investing in G-Secs and/or SDLs have virtually no risk of default while those investing in high credit quality PSU Bonds also have a negligible credit risk.

Redemption Risk or Exit Risk

In case you redeem the units before maturity of the fund and the interest rates rise during the time of your redemption, the prices of the bonds held by the fund are likely to fall. Due to this phenomenon, you could get returns relatively lower than you had envisaged while investing in the fund.

On the contrary, in case the interest rates decrease, the prices of the bonds held under the fund may start to rise and if you choose to exit early, you might be able to benefit from the uptrend.

What is the difference between Target Maturity Index Funds and Fixed Maturity Plans (FMP)?

Both Target Maturity Index Funds and FMPs have fixed maturity dates. However, the main difference between the two is liquidity. FMPs are close ended schemes; there is no liquidity before the maturity of the scheme. Target Maturity Index Funds, on the other hand, are open ended scheme. You can redeem units of your Target Maturity Index Funds at any time, as per your needs based on prevailing Net Asset Values (NAVs). The other difference between the Target Maturity Index Funds and FMPs is the type of securities in which these schemes can invest. Target Maturity Index Funds can only invest in G-Secs, SDLs and Corporate bonds including PSU bonds, while FMPs can invest in other types of debt instruments also.

Should you invest in Target Maturity Index Funds now?

The yield curve has been flattening over the past 6 months or so. Flattening yield curve means that short term bond yields are rising faster than long term bond yields and implies that inflation expectations are falling and possible reversal of interest rate trajectory. Since yields are attractive, you can lock in these high yields by investing in target maturity index funds and holding them till their maturity dates. Once locked-in you will get the yield till the maturity date, even if interest rates come down in the future. If you need liquidity before maturity of the fund, you can redeem them at prevailing NAVs like any other open ended fund. For investment tenures over 3 years, you can also get benefits of long term capital gains taxation. Long term capital gains in debt funds are taxed at 20% after allowing for indexation benefits.

Investors should consult with their mutual fund distributors if target maturity index funds are suitable for investment needs.

Issued as an investor education initiative by HSBC Mutual Fund.