May 18, 2023

Debt investments should focus on both duration risk and gains from rate cycle reversal

When rates are anticipated to peak out and the cycle is set for a reversal in the next year or later, investors have a number of alternatives for locking in yields at current levels. One of those possibilities is Target Maturity Funds (TMF). The majority of target maturity schemes are currently on the market, and the average maturity is anticipated in 4-5 years. Since this residual maturity time will have little effect on interest rate volatility, investors are exploiting it to lock in yields at their present high levels and profit from the low duration risk. 

Investors in TMF should be aware that while they will benefit from the low duration risk, they will mostly miss out on the duration-led capital gains that a long duration income funds has a great potential to deliver. Hence, allocation in other debt instruments in addition to Target Maturity Funds will help investors maximise returns and reduce volatility.

Since Target Maturity Funds only invest in sovereign or quasi-sovereign bonds, the credit risk associated with this investment is minimal. Investors wanting predictable returns within a 3–4 year maturity period choose these funds.  But the disadvantage in this case is the rate reversal's limited gains. Consequently, there should be strategic allocation to various debt funds, including TMF and other Long-Term Fixed income funds with modified duration of more than 6-7yrs at-least, in order to optimise the opportunity available due to the end of the rate cycle. A bias in favour of long-term plans is the idea. 

With most TMFs having residual maturities of 4 to 5 years, investors will undoubtedly gain from indexation as the target maturity is more than 3 years. Moreover, the expense ratio associated is comparatively lower, given that TMFs follow a passive strategy of buy and hold. 

Target Maturity Funds are passively managed, allowing investors to see who makes up the index and see where their money is going. TMFs are also planned to mature at a particular time, giving investors a good indication of what the returns are expected to be. Investors who intend to associate this investment with a certain objective typically find this to be helpful. 

Investors should combine Target Maturity Funds (TMF) with Long Term Income Funds at the current rate levels when rates are peaking in order to gain from both the duration risk supplied by TMF and the gains from the rate cycle reversal that Long Term Income Funds would provide. 


Uses for Blockchain in the Financial Services Industry 

GST Implications on Non-Fungible Token (NFT)

GST Implications on Non-Fungible Tokens (NFTs) in India: