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How target maturity funds help manage risk in debt investment

How target maturity funds help manage risk in debt investment

26 Sep 2021

There are two types of risks in debt funds: volatility risk (also known as interest rate risk or duration risk) and credit risk. There are certain types of funds that minimise either of these two risks. Government security funds (a.k.a. gilt funds) do not have credit risk, but carry volatility risk as the portfolio maturity is relatively longer.

Shorter portfolio maturity funds e.g. liquid funds or other money market funds, have lower duration risk, but carry an element of credit risk.

One method of managing volatility risk is following hold-till-maturity (HTM). This concept can be practised by investing directly in bonds. On maturity of the bond, money flows back to the investor and returns are not dependent on market conditions at that point in time. In mutual funds, fixed maturity plans (FMPs) work on this principle. If it is a three-year FMP, on maturity, all the bonds in the portfolio mature and there is no market/volatility risk.

For credit risk management, G-Secs are assumed to be risk-free. Next to Gilts, securities issued by states, known as state development loans (SDLs), are placed in the same category as G-Secs. AAA-rated PSU bonds also are of very high credit quality, next to G-Secs.

The approach to risk management

In the light of what is mentioned above, this three-pronged approach helps:

  • In a mutual fund scheme, do an HTM. While FMPs are usually of three-year maturity, have funds with multiple maturities e.g. three years, six years, 10 years etc. This will suit investors to match with their cash flow horizons. Rather than the choice being limited to three years, multiple options will help. The scheme matures on the defined date and money flows back to investors.
  • Ensure liquidity. Though FMPs are listed on the exchange, there is no liquidity. If an investor requires liquidity prior to the maturity of the product, the outlet should be there.
  • Ensure a good portfolio credit quality. Let the portfolio comprise government securities, SDLs and AAA-rated PSU bonds.

Enter target maturity funds

The concept that encompasses all the ideas mentioned above is a target maturity fund (TMF). These are open-ended funds, unlike FMPs, which are close-ended. There is a defined maturity date on which the fund matures. Prior to maturity, liquidity is available. To understand the format of how these funds are organised and liquidity is made available, let us look at the two kinds of structures followed by TMFs.

One format is called index fund. An index fund is one that follows the designated index. The fund manager does not play an active role, just follows the index. In this format, purchases and redemptions happen with the AMC, like in any other fund.

The other structure is exchange traded fund (ETF). In an ETF, the units of the fund are listed on the stock exchange, where investors buy and sell. In ETFs, liquidity is generally better than FMPs, but is subject to counterparts being there on the exchange. In an ETF, there is no purchase/redemption with the AMC in the normal course, except for very large lots of purchases known as creation units. Moreover, you require a demat account and a trading account with a stockbroker to transact in ETFs.

For clarity, (a) one fund cannot be available as both index fund (transactions with the AMC) and ETF (transactions at the exchange) and (b) a TMF-structured as ETF also follows the designated index, but is not called index fund to signify that it can be purchased and sold only on the exchange.

The portfolio quality of TMFs, at least the ones we have seen so far, is of very high credit quality. The portfolio comprises either government securities or SDLs or AAA-rated PSU bonds or a combination of SDLs and AAA-rated PSU bonds.

What are the products available?

In the index fund format, we have IDFC Gilt 2027 Index Fund and Gilt 2028 Index Fund. These two funds have a maturity of approximately six years and seven years from now. The portfolio comprises G-Secs. ICICI Prudential AMC has come out with an NFO called PSU Bond plus SDL 40:60 Index Fund – Sept 2027. The portfolio comprises 40% AAA rated PSUs and 60% SDLs. The YTM of ICICI Prudential PSU Bond plus SDL 40:60 Index Fund – Sept 2027 (as per the index) is 6.28%.

In ETFs, there are Bharat Bond ETFs of various maturities; April 2023, April 2025, April 2030 and April 2031. The portfolios comprise AAA-rated PSU bonds. Then there is Nippon India ETF Nifty CPSE Bond Plus SDL – 2024 and ETF Nifty SDL – 2026 with SDL-based portfolios.

There are various maturities of TMFs available as mentioned above; pick funds as per your cash flow requirements.

(Joydeep Sen is a corporate trainer and author. Views are his own)