Target maturity funds are fine but beware of the reinvestment risk
The impact of reinvestment risk on return is modest except in the most extreme scenarios
Target Maturity Fund (TMF) —an open-ended index fund that passively invest in securities with a defined fixed maturity—has gained a lot of traction in the last few years.
TMFs provide some degree of return predictability for those who stay invested until the maturity of the scheme. For example, BHARAT Bond ETF—April 2031—launched in July 2020 and replicates the portfolio of Nifty BHARAT Bond Index—April 2031—has a current yield to maturity (YTM) of 7.7%. That means, a person who is now investing in the fund, which if held till maturity, may earn a return of 7.7% per annum.
The risk of TMFs not generating the return as estimated at the time of investment can primarily emanate from two reasons: One is the tracking error— divergence in the returns of a TMF compared to benchmark due to portfolio positioning at various times. The other is the re-investment risk—reinvesting interest income earned by the portfolio at a lower rate compared to the yield at the time of investment.
Check the tracking error before investing. Funds with low tracking error are comparatively better. Here, we write what investors should know about the reinvestment risk and the kind of impact it could have on the overall returns in various scenarios.
Reinvestment risk
TMFs are not very attractive in a rising interest rate scenario. This is because investors get locked in at lower interest rates and this may have an adverse impact on the overall return especially when interest rates are likely to go up in the future.
Currently, experts believe that we are close to the peak in an interest rate cycle, given the macro-economic conditions. In India, the yield of 10-year G-sec instrument has gone up from 5.8% in mid-2020 to almost 7.3% now. TMFs with a residual maturity of 4-5 years currently offer YTM of 7.5-7.7% per annum at the end of February.
In this scenario, investing in TMFs is viewed as a good opportunity to lock the investment at higher estimated YTM, if held till maturity.
Having said that, “the disadvantage of the YTM formula is that it assumes that every subsequent cash flow (interest income) is also reinvested at the original yield, which is never the reality,” said Vishal Chandiramani, chief operating officer at TrustPlutus.
In simple words, the underlying bonds keep paying the interest, which gets reinvested at prevailing rates at that time and not the yield at the time of investment. If we are already at the peak of an interest cycle, chances are that the subsequent cash flows will get reinvested at lower rates. This will bring down the estimated yield from the investment.
The impact of reinvestment risk depends on how low the yields are at the time of reinvestment vs starting yields, said Arun Kumar, head of Research at FundsIndia.
Take, for instance, a TMF maturing in about 9.5 years and offering 7.5% YTM at the time of investment. If all the future cash flows are assumed to have been reinvested at a lower interest rate of 6.5% (about 100 basis points, or bps, lower), the actual return would be 7.3%, 20 bps lower than the original YTM. In the worst-case scenario of future yields falling to 5.5%, the return on investment would be about 7.1%, 40 bps lower than the original YTM of 7.5%. (One basis point is one-hundredth of a percentage point.)
This shows that the impact of reinvestment risk is not significant. The above calculation assumes that all future cash flows will be invested at the same rate, which may not be the case, but gives a fair idea about the impact of reinvestment risk. Also, the reinvestment risk would be higher as the duration of the TMF goes up.
“For a 3-5 year TMF, even if the reinvestment happens at lower yields (about 100 bps lower than current yields), there may be just a 10-20 bps impact in returns,” said Kumar.
Note that, on the other hand, if the interest rates go up, the future cash flows would be reinvested at a higher rate. In that case, one can expect to earn at least the estimated YTM at the time of investment, if not higher.
What should you do?
To reduce the reinvestment risk that comes with TMFs, one can consider investing in funds maturing in 3-5 years compared to long term TMFs with tenure of 10 years and more, suggested Kumar.
Not just that, currently the 3-5 year tenure is also considered a sweet spot among the multiple maturity brackets available. For those bonds with tenure beyond that, the uptick in the yield from one tenure to next is not high enough and the risk reward is not favourable.
Kumar also suggested that investors account for 20-30 basis points lower than the estimated YTM at the time of investment in TMFs. This could help in managing the expectations better, he opined.
Almost all TMFs invest in relatively safer instruments such as G-sec, state development loans (SDLs) and AAA-rated papers due to which credit risk of these products is lower. Further, holding till maturity also mitigates the interest rate risk that results in the mark to market losses on investment due to interest rate movements in the economy.
Thus, investors who have financial goals that match the tenure of these funds can consider investing in TMFs over fixed deposits, given the tax efficient structure of the former.
Returns from TMFs are taxed at 20% after indexation if held for more than 3 years. The short-term capital gains from TMFs are taxed at slab rates of the individual – similar to the tax treatment of interest earned from bank fixed deposits (FDs).
Vishal Dhawan, a Sebi-registered investment adviser, also pointed to the risk of future fresh inflows into the TMF invested at a lower rate. “Future cash flows from new investors invested at lower yields can pull down the entire yield of the fund. The only way to avoid this is to invest in a close-ended FMP (fixed maturity plan) which does not take any fresh inflows after the subscription period. Having said that, in the trade-off between liquidity and slightly higher return, investors are suggested to go for open-ended TMFs,” added Dhawan.
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First Published:21 Mar 2023, 12:37 PM IST
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