Target maturity funds are better than FMPs for locking in returns

They are more transparent and control both interest-rate and credit risk

A number of asset management companies (AMCs), such as HDFC, Kotak, Tata, Axis, HSBC and Union have filed their offer documents with the Securities and Exchange Board of India (Sebi) for launching target maturity funds (TMFs) and fixed maturity plans (FMPs). Investors, who wish to lock into prevailing returns by investing for a fixed period, will have to choose between the two categories.

The similarities

Defined tenure: Both TMFs and FMPs have defined tenures. “Both have a start and end date. By holding them till maturity, investors can eliminate the mark-to-market impact of rising interest rates,” says Munish Randev, founder and chief executive officer (CEO), Cervin Family Office and Advisors.

Know what to expect: An investor investing in them gets a good sense of the return to expect. In a TMF, the investor can look at the yield to maturity (YTM), deduct the expense ratio, and know the approximate return to expect if she/he holds it till maturity. In an FMP, distributors indicate to investors the returns they are likely to earn.

The differences

Open- and closed-end: TMFs are open-ended funds. An investor can enter and exit them whenever she/he wants. A TMF can be launched in the exchange-traded fund (ETF), fund of fund (FoF), or index fund format. In both FoFs and index funds, the investor can buy and sell units from the fund house. In an ETF, she/he has to find a buyer on the exchange to exit before maturity. “Liquidity tends to be better in an ETF than in a closed-end fund listed on the exchange because in the former, there are market makers whose task is to generate liquidity,” says Joydeep Sen, author and corporate trainer (debt markets).

FMPs are closed-end. Investors can enter into them during the new fund offer (NFO) period. They are listed on the stock exchanges but liquidity tends to be low.

Availability universe: FMPs usually have a tenure of up to three years or slightly higher. In TMFs, the tenure can go up to 10 years or more. “The investor can choose from a wider range of maturity options in TMFs,” says Sen.

Credit quality: TMFs tend to have portfolios with very high credit quality as they hold government securities (G-Secs), state development loans (SDLs), and AAA-rated PSU bonds. “TMFs aim to negate not just interest-rate risk but also credit risk,” says Randev.  

FMPs largely invest in corporate bonds. The credit quality of the portfolio can vary.

TMFs are more transparent. The fund invests in a publicly available index whose constituent investors can see before they invest. Moreover, these indices are based on clearcut rules regarding what can be included. Fund managers can’t deviate from the index while building their portfolios.

In FMPs, the portfolio constituents can change during their tenure. “In the past, FMPs have served as a dumping ground for poor-quality bonds during periods of high credit risk,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor.

Reinvestment risk: The bonds held by both TMFs and FMPs earn interest, which is reinvested. “At the time of reinvestment, the bonds that are available may not offer the same yield, forcing the fund manager to invest at lower yields. This risk is more pronounced in TMFs since they have a longer tenure,” says Randev.

Drag on returns: In any open-end fund (TMF), cash comes in and goes out. The fund house has to keep a portion of the corpus as cash to meet redemption requests. Also, the index constituents can change. The fund manager has to sell old bonds and buy new ones. Both these factors create a drag on returns.

This doesn’t happen in the case of FMPs which are closed-end.  

What should you opt for?

Most experts say retail investors should opt for a TMF. The portfolio quality is superior, liquidity is higher, there are more maturity options, and they are more transparent. Fund houses also offer them with attractive expense ratios.

Tips for investing in a TMF

• Check your cash flow needs, see which TMFs are available for that period, look up their portfolios and yield to maturity (YTM), then invest
• If you can be flexible on investment horizon, check out the YTMs for various tenures, and choose the most attractive one
• Both portfolio and YTM are available in the fact sheet available on AMCs’ websites
• If you exit before maturity, you could end up with a low or even negative return in a rising rate scenario