With the RBI expected to hike interest rates sooner rather than later, debt mutual funds, especially those investing in longer-dated papers, are expected to see a fall in their NAVs. The post-Budget spike in government bond yields (and fall in bond prices impacting NAVs) gave investors a glimpse of this. 

Target maturity debt funds (TMF,) too, are exposed to interest rate risk, that is, a markdown in NAVs when bond yields rise and (bond prices fall). However, investors can avoid risk by remaining invested in a TMF until maturity. TMFs are debt funds with a defined maturity that invest passively in the bonds constituting a particular index. The funds hold these bonds till maturity, earning interest, which gets reinvested in similar bonds. On maturity, investors are returned their principal plus return.

The two latest new fund offers (NFOs) in the TMF space are the Axis CRISIL SDL 2027 Debt Index Fund and the Kotak Nifty SDL April 2032 Top 12 Equal Weight Index Fund. The NFOs are open until 21 and 9 February 2022, respectively. 

Return and safety 

The Axis MF TMF will invest in CRISIL IBX SDL Index – May 2027, which comprises SDLs (state government bonds) issued by 12 different state governments that will mature within a few months up to May 2027. The yield to maturity (YTM) of the index is 6.6 to 6.8 per cent. That is, if you invest today and stay put for five years until May 2027, your return will approximately equal YTM minus the scheme expense ratio. The Kotak MF TMF will invest in 12 different state SDLs that form part of Nifty SDL Apr 2032 Top 12 Equal Weight Index which will mature around April 2032. That is, the fund grows in ten years from now. The index YTM is around 7.5 per cent. The expense ratios will be known after the new fund offers close. 

Like other TMFs, the two new funds too, offer a high degree of safety as they will invest only in the sovereign guarantee-backed SDLs. Caps on weights assigned to the bond issuers in the index will keep concentration risk under check. 

The existing Nippon India ETF Nifty SDL – 2026 is another TMF focused only on SDLs. It invests in the Nifty SDL Apr 2026 Top 20 Equal Weight Index. As of January 31, 2022, the index had a YTM of 6.1 per cent. The fund matures in 2026 and charges an expense ratio of 0.15 per cent. Unlike the newly launched index funds, the Nippon India MF offering is an ETF. While you can invest in and redeem your investment in an index fund via the AMC, ETFs can be bought and sold only on the exchanges (except for bulk transactions). Investors must, therefore, check an ETF’s daily traded volumes on the exchanges before investing.

Invest or not? 

It makes sense to invest in a TMF where the maturity matches your investment horizon. This provides you wtih return predictability and protects you from the possibility of capital loss in a rising interest rate scenario. For example, the Axis MF TMF may be suitable for someone with a five-year investment horizon.

The returns offered by these TMFs are attractive compared to bank FD rates, especially those in the higher tax brackets (say, 20 per cent and higher) and with an investment horizon of three years or longer.

Many leading public and private sector banks are offering 5.4 to 5.75 per cent per annum on their 5-year and 10-year fixed deposits. Senior citizens get an additional 0.50 percentage point on these rates. Interest income from bank deposits is taxed at your income tax slab rate. On the other hand, gain on sale of debt funds after being held for three years or longer (long-term gain) is taxed at 20 per cent with indexation benefit. This can reduce your tax liability substantially.