What are the disadvantages of investing in target maturity funds?

Target maturity funds
(TMFs) are a kind of open-ended debt funds that offer fixed maturity dates. The portfolios of these funds have bonds whose maturity date is aligned with the expected maturity date of the fund, and all bonds are held to maturity. While this helps reduce interest rate risk and makes returns more predictable, investors need to keep the disadvantages of TMFs in mind before investing in these funds.

Target Maturity bond funds are a new category of debt funds and so there are few options available in this space. This may limit an investor’s choice of maturity, i.e. investors interested in a specific maturity horizon may not be able to find a suitable fund. In addition, the category has no performance track record to rely on.

The benefits of the target maturity fund include interest rate risk mitigation and return visibility. But both of these benefits can only work if the investor stays invested in the fund until maturity. Therefore, investors may end up earning lower yields and also be prone to interest rate volatility if they have to liquidate their investments before maturity during an emergency. TMFs should only be considered if you have a medium-long-term goal of 5-7 years and if you can hold your investments until the fund matures.

The biggest disadvantage of target maturity funds is that investors get stuck on prevailing interest rates and this could have a negative impact on overall return, especially when interest rates are likely to rise in the future. This is usually the case when the economy is just coming out of a recession or the government is likely to withdraw an ongoing stimulus package because, in both of these scenarios, interest rates are usually at their lowest and therefore are likely to only rise. Rising interest rates have a negative impact on bond prices and debt fund yields.

Because TMFs invest in an underlying bond index, these funds are as prone to tracking errors as any other index fund. Although the category has no history of performance, underlying bond indices can be a reasonable indicator of the expected returns of a specific TMF. However, tracking error, i.e. the difference between the actual returns of the fund and the performance of benchmarks, can be the spoiler here in the predictability of return.

Being passive in nature, the fund manager has a limited scope to manage various risks should the outlook for the debt market change in the short term, such as a change in a credit rating or an RBI making changes in interest rates. The manager has no choice but to keep the bonds in the underlying index regardless of his prospects. Therefore, this may not be favorable to investors who are looking for short-term investments in debt funds. It would be better to invest in shorter-dated funds instead of TMF.

You should carefully weigh the pros and cons of Target maturity funds before choosing to include them in your investment portfolio. Also, a Demat account is mandatory to invest in target expiry funds available in ETF format which could be a limitation in case you don’t have one.

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