With investors taking favourably to initial offerings of passively managed target maturity bond funds, AMCs are clamouring to get a slice of the pie. Nearly every big AMC is launching TMFs spanning maturities and instruments. With the variety on offer, what type of TMF should you opt for?
Domestic investors first got a taste of TMFs in 2019 with the launch of Bharat Bond ETF series 2023 and 2030. Two additional funds were offered in 2020—Bharat Bond ETF series 2025 and 2031. It was the first time debt fund investors were offered a portfolio of pristine credit quality bonds packaged in a low-cost passive vehicle with a defined maturity.
The pack of AAA-rated PSU bonds gave comfort of safety amid a litany of credit-led mishaps in debt funds. The index avatar lent a degree of transparency about what the fund portfolio would comprise while doing away with fund manager discretion. The expense ratio was much lower than that charged by actively managed open-ended debt funds. The pre-defined maturity allowed a degree of predictability of return and put a lid on interest rate risk, yet afforded easy liquidity by facilitating exit at any time. This potent co*cktail makes a compelling alternative for investors looking for a safer route to earn good yields. The big splash made by the initial offerings opened the taps for newer, diverse TMFs. A spate of launches followed.
AMCs now offer plain-vanilla Gilt index TMFs (comprising government securities) and SDL index TMFs (state development loans). Investors also have the pick of combo TMFs in the form of PSU bonds plus SDL index funds and Gsec plus SDL index funds. Additionally, the combo funds are packaged in different ratios like 35:65, 50:50, 60:40, 70:30 and various permutations of these. Thirty six funds are already active in this space, barely three years after the first one got out of the door.
Many more are waiting for regulatory approval. This will introduce investors to newer flavours. Add to this the different maturity profiles with funds catering to multiple maturity buckets ranging from year 2023 to 2032, and beyond. The plethora of options is sure to confuse investors. How does one resolve this dilemma? A natural habit for many is to opt for TMFs offering higher yield.
The prevailing yields in these funds range from 6.4% at shorter maturities to 7.7% for longer tenures. While the yield is only indicative, investors can expect to fetch returns close to this yield minus the fund expense ratio. But picking a TMF simply on the basis of yield is not the right approach. Kirtan Shah, Founder, Credence Wealth Advisors, asserts, “Don’t go for a longer maturity fund just for capturing that 10-20 bps higher yield. The incremental time exposure may carry some opportunity cost.”
Experts suggest investors first identify the right maturity buckets. Investors must align their own time horizon with the fund tenure. For instance, if you have cash needs 3 and 5 years from now, you may simply split your capital across two target maturity funds with matching tenures. Others may identify a different set of maturity buckets. Amol Joshi, Founder, PlanRupee Investment Services, exhorts, “Invest in a TMF that matures around the same date or few weeks prior to the targeted date for your planned outlay.” The choice of underlying bonds—gilt, PSU or SDL and any combo thereof—is largely immaterial from a safety perspective, reckon experts. All these instruments boast superior credit quality.
To be sure, plain-vanilla central government bonds always rank supreme on this front. But SDLs and PSU bonds are not that far behind on the quality curve. SDLs are debt issued by state governments to fund their fiscal deficit. While there is no explicit sovereign guarantee on SDLs, the risk of default is virtually nil under the RBI-led mechanism of repayments. The central bank has the power to make repayments to SDLs out of the central government allocation to states.
It maintains a reserve fund for meeting contingent liabilities arising out of borrowings by state undertakings. At times, loans taken by state governments with shaky financials or widening fiscal deficit may trade at higher spreads. But this usually evens out in the long run. AAA-rated PSU bonds rank only slightly lower than SDLs on credit quality. Still, the credit rating is highest among corporate bonds, even if not as comforting as a sovereign guarantee.
Shah remarks,“Even though credit profile is not an issue in these instruments, theoretically, AAA PSU bonds would rank lowest on credit risk, followed by SDLs and then gilts.” Investors can safely pick a TMF with any combination of these instruments, experts maintain. Joshi insists, “While credit quality among these instruments varies to some extent, choosing one over the other is not likely to materially alter the risk profile.” Once you zero in on specific maturity buckets, investors can take their pick on the basis of prevailing yields and expense ratios. Given the slight difference in credit profile, yields on funds with different underlying instruments will vary even for similar maturities.
Within a maturity bucket, if two funds with similar expense ratios are running noticeably different yields, go for the fund with the higher yield. Shah argues, “If you are getting a material difference in yield, go for a PSU bond or SDL-led TMF over a gilt-based TMF.” Avoid picking a fund if its expense ratio is much higher than others in its maturity bucket. If investing via index ETFs, be mindful of liquidity and spreads. Index funds are a better choice to avoid mispricing issues. Finally, stay invested till maturity to negate interest rate driven price swings.
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