Stepwise guide to choose the appropriate target maturity fund

Why and how to choose a target maturity fund for your investment portfolio?

Target maturity funds are debt funds with a specified maturity period. Such funds carry considerably low interest rate risk and offer a more stable and predictive scope for capital appreciation, which makes them suitable for investors who prefer predictability and stability. Herein, we discuss target maturity funds and how to select a suitable fund.

What’s a target maturity fund?

Target maturity fund investments are passive investments in debt papers and bonds in the same proportion as the benchmark index. In terms of structure, such funds are identical to equity-traded funds (ETFs) or index funds, which replicate their benchmark indices. In sum, a target maturity fund invests in the constituents of a debt or bond index with the aim of reflecting the performance that index rather than outperforming it.

How are the returns on the target maturity fund predictable?

A target maturity fund purchases bonds and other debt securities and holds them till maturity. Therefore, the capital appreciation offered by the fund can be expected to be close to the net Yield-to-Maturity (YTM) at the time of investment.

However, the original capital appreciation may vary in case of the occurrence of any of the below-mentioned events:

• When you exit the investment early

Target maturity funds carry the lowest credit risk because they invest in AAA-rated debt papers and sovereign securities with minimal chances of default. While credit risk may not be involved, the capital appreciation provided by such funds may be susceptible to interest rate risk.

The open-ended structure of target maturity funds allows you to liquidate your investment at any time. If you exit before the maturity of the fund, your capital appreciation might deviate from the theoretical number, which is determined based on the prevailing rate of interest. Note that you can avoid this risk by holding your target maturity fund investment until maturity.

• When the interest you receive is reinvested at different yields

When target maturity funds earn interest on their bond investments, then they tend to purchase more bonds with this interest money. Such reinvestments may be made in instruments whose yields may be lower or higher than the original yields depending on the prevailing interest rate regime. Nonetheless, such reinvestment risk is extremely low, especially for funds with shorter maturity periods (usually up to five years).

• When there may be other operational challenges and changes

Because bonds offer lower liquidity, the managers of target maturity funds might face a few difficulties in mimicking performance of the benchmark index. Moreover, funds hold a portion of assets in cash equivalent, which may generate lower yields. Moreover, there may be other operational changes such as expense ratio revision. The possibility of earning low returns owing to operational challenges and changes is low because the fund invests in top-rated papers that have low chances of default with high predictability to earn the expected returns if the investment is held until maturity.

Which target maturity fund is ideal for you?

The appreciation offered by target maturity funds is close to YTM if the investment is held until maturity. Additionally, the fund yields accrual returns. Thus, the fluctuating rate of interest does not affect the fund’s overall yield upon maturity.

Your selection of a suitable target maturity fund must be based on your financial goals and investment time frame to fulfill those goals. As target maturity funds offer maturity periods between one and fifteen years, they can be used for long-, medium-, and short-term goals. If you are a risk-averse investor and do not wish to face market volatility to increase your scope for capital appreciation, you may consider investing in a target maturity fund.

Ending note

Investing a part of your money in a target maturity fund, a potentially low-risk investment, depending on your financial goals and investment horizon may help you secure satisfactory and stable yields.

Target maturity funds have distinct investment time frames. They may be short-, medium-, or even long-term in nature. However, there is a high chance of attracting interest rate risk if you redeem your investment before the maturity date. You can avoid this risk only if you hold your investment in such funds until maturity. Moreover, doing so would help you earn the maximum possible yield close to the YTM.

Source: Axismf Research

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