I am looking to invest in a debt fund as part of my asset allocation for the long term. Should I opt for a constant maturity fund or target maturity fund? Are they the same? If I invest today and hold for 10 years, will the return in both funds be similar to today’s yield? Are these funds substitutable in my portfolio?
—Name withheld on request
A constant maturity fund is very different from a target maturity fund. They are not substitutes for each other.
A 10-year constant maturity fund aims to maintain an average portfolio maturity at 10 years at all times. It can do this by mixing gilts (government bonds) of different maturities such that the portfolio’s maturity is around 10 years or holding gilts of a 10-year maturity. It doesn’t matter when you invest in the fund – the maturity will always be around that level. In such funds, you take on interest rate risk. That is, changes in the interest rate cycle will impact bond prices and therefore the fund’s returns. A rising rate cycle pulls down returns as bond prices fall, and vice versa.
A constant maturity fund’s returns can change from the portfolio yield-to-maturity at the time you invested; not just because of the rate cycle impact but also because funds can actively book profits when bond prices rise to bulk up returns. You can hold these funds for any number of years.
A target maturity fund, on the other hand, doesn’t maintain a specific maturity—it is just the maturity date that is fixed. The fund will see its maturity reduce as the target date nears. These funds also match the bonds held in the portfolio to the maturity date, and don’t actively juggle this around.
Here, if you hold the funds to maturity, the interest rate impact is largely extinguished. You are more likely to get returns around the yield to maturity at the time of your entry.
If you want to include target maturity funds in your portfolio, try to keep your holding period matched with the fund’s maturity. This limits both reinvestment risk and interest rate risk.
Srikanth Meenakshi is co-founder at PrimeInvestor.