TMF: Best way to lock in yields at the end of rate cycle

There is a general consensus that we may be heading towards the end of a rate hike cycle. With the economic cycle advancing from slowdown to growth, it is very likely that the Reserve Bank of India would pause before moving on to a rate cut phase. As investors, what should you do to benefit from this scenario?

Target maturity fund – an optimal solution

One of the easiest ways to lock-in investments at the prevailing higher yields is through a target maturity fund (TMF). TMFs are passively managed debt mutual funds which replicate the composition of the underlying debt index and their maturities. They can be in the form of an ETF or an index fund. The portfolio typically consists of government securities, PSU bonds, corporate bonds and state development loans.

Also Read | E-wallets for investing in mutual funds should be KYC norms compliant: Sebi

As the name suggests, TMFs have a fixed maturity date and, if your investment horizon aligns with this date, then you have the opportunity to lock in your returns at the present high rate of interest. This is possible because TMFs invest in bonds with the intention of holding them till maturity. So, when you invest in a 10-year TMF, you place your investment in a scheme which invests in bonds with 10-year maturity, which will continue to enjoy the prevailing coupon rate, even when the rates turn lower down the years.

The structure of these funds works on decreasing residual maturity, which means that, each passing year, the maturity of the underlying bonds keeps reducing. In this way, the duration risk keeps going down, while the maturity date remains the same, making the returns from the offering predictable. For example, an investment in a TMF of ICICI Prudential PSU Bond Plus SDL 40:60 Index Fund-September 2027, with a leftover maturity period of 4 years, will typically have a lower duration risk.

In addition to this, you will benefit on the tax front as well, when compared to traditional investment avenues, because TMFs are taxed at 20% after indexation, as long as your investment has a tenure which is greater than 3 years. Further, TMFs only invest in sovereign or quasi- sovereign bonds, hence the credit risk on these investment is negligible.

Should you invest in a TMF?

An investment in TMF, in the current scenario, works out on three fronts: locks in the yield that can be received on maturity, brings down your duration risk and offers you the indexation benefit as long as your target maturity is beyond three years. Further, the expense ratio associated is comparatively lower, given that TMFs follow a passive strategy of buy and hold. Given these are passively managed, you can view the index constituents and know where your money is being invested.

Since a TMF is designed to mature at a specific date, investors will have a fair idea of their likely returns. This tends to be helpful for those who are planning to tag this investment with a specific goal.

Now that you know why this is an opportune time to make TMFs a part of your portfolio, find a scheme which is most aligned with your investment horizon and lock in the high returns.