Debt Investing: Consider Target Maturity Funds

Dec 01, 2022

If interest rates are likely to rise further, should I invest in overnight funds, liquid funds or target date funds?

This question is increasingly being asked by readers. Let me break up it when answering as the assumption that interest rates are likely to rise is faulty. This will give clarity and and answer the question.

  • Interest Rates

Over the past six to nine months, interest rates have seen a sharp upswing particularly since the Reserve Bank of India (RBI) initiated its rate hike cycle earlier this year.

The RBI has hiked the repo rate by 190 bps (or 1.90%) cumulatively, resulting in short term interest rates (such as on one-year Treasury bills, CDs, etc.) moving up by 200 to 250 bps. Similarly, yields on longer dated government securities and AAA rated bonds have risen by 80 to 100 bps during this period.

Given that inflation has seen a downtick recently, although it remains above RBI’s target range, further interest rate increases may be muted.

  • Target Maturity Funds

Going ahead, bond yields across the maturity spectrum (short to long term) may not witness sharp upswings from current levels. Bond yields at the mid to long duration segment (five- to 10-year) are looking attractive and one can invest a portion (30-40%) of their debt allocation into this segment via target maturity funds with an investment horizon of three to five years. The remainder can be allocated to short-term funds.

Target maturity funds are passive (ETFs or index) debt mutual fund schemes, tracking an underlying index. They are open-ended funds that have defined maturity dates. On the maturity date, investors holding units of target maturity funds will get the principal amount along with accrued interests.

Such funds invest in Government Securities (G-Secs), State Development Loans (SDLs) and PSU bonds that mirror an underlying bond index. G-Secs enjoy sovereign status and are the safest. SDLs enjoy quasi sovereign status because the interest and principal payments come from the state government’s budget. PSU bonds are safe because PSUs are owned by the government. As a result, the credit quality of target maturity funds is very high.

  • Liquid and Overnight Funds

Liquid funds are ideal for short term (normally up to 3 to 6 months) parking of money and returns are aligned to prevailing yields on short-term instruments. Liquid funds hold securities with maturities up to three months, such as Certificate of Deposit (CD), Commercial Paper (CP), Treasury Bills (T-bills), and repos.

Overnight funds (as the name suggests) invest into overnight instruments such as reverse repo and TREPS. Also, overnight funds have no exit load while liquid funds have a nominal graded exit load up to 6 days (0.007% on day 1).

As the duration is low, there’s minimal interest rate risk in such funds. As these are open-ended funds, one can stay invested and redeem as required.

In case your holding period exceeds six months, you can invest in ultra short-term funds or other debt funds based on the investment horizon. The yields on these fund categories would tend to be higher than liquid funds.  However, these involve relatively higher credit and duration risk.

One should also evaluate the expense ratio of the underlying fund before investing, as lower expense ratio funds result in higher returns assuming other fund attributes are similar.

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