Target maturity funds are fine but beware of the reinvestment risk

TMFs are not very attractive in a rising interest rate scenario as investors get locked in at lower interest rates

- Satya Sontanam & Neil Borate

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.