What are the disadvantages of investing in Target Maturity Funds?

Target Maturity Funds (TMFs) are a kind of open-ended debt funds that offer you fixed maturity dates. The portfolios of these funds carry bonds whose expiry date is aligned with the fund’s target maturity date and all the bonds are held to maturity. While this helps in lowering interest rate risk and makes returns more predictable, investors must keep in mind the drawbacks of TMFs before investing in these funds.

Target Maturity bond funds are a new category of debt fund and hence there are few options available in this space. This may limit the choice of maturity available to an investor i.e investors keen on a specific maturity horizon may not be able to find a suitable fund. Also, the category doesn’t have any performance track record to rely on.

Target maturity fund benefits include interest rate risk mitigation and return visibility. But both these benefits can work only if the investor remains invested in the fund till maturity. Hence, investors may end up earning lower returns and also be prone to interest rate volatility if they have to liquidate their investments before maturity during an emergency. TMFs should only be considered if you have a medium to the long-term goal of 5-7 years and if you can hold on to your investments till the fund matures.

The biggest disadvantage of Target Maturity Funds is that investors get locked into prevailing 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. This is usually the case when the economy is just coming out of a recession or the government is likely to pull back an ongoing stimulus package because, in both of these scenarios, interest rates are usually at their lowest and hence are only likely to go up. Rising interest rates have an adverse impact on bond prices and debt fund returns.

Since TMFs invest in an underlying bond index, these funds are prone to tracking error like any other index fund. While the category doesn’t have a performance history, the underlying bond indices can be a reasonable indicator of the expected returns from a specific TMF. However, tracking error i.e the difference between actual fund returns and return of the benchmarks can be the spoilsports here in return predictability.

Being passive in nature, the fund manager has limited scope to manage various risks should the outlook for the debt market change in the short-term like a change in a credit rating or RBI making changes to interest rates. The manager has no choice but to hold on to the bonds in the underlying index irrespective of his/her outlook. Hence, this may not be favourable to investors who are looking for short-term investments in debt funds. They would be better off investing in shorter maturity funds instead of TMFs.

It is advisable to weigh the pros and cons of Target maturity funds carefully before choosing to include them in your investment portfolio. Also, a Demat account is mandatory for investing in Target Maturity Funds that are available in ETF format which could be a limitation in case you don’t have one.