Investing In Target-Date Debt Funds
Target-date funds or target-maturity funds are like index funds or exchange-traded funds (ETFs) and have been structured in a way that will help you grow assets optimised for a specific timeframe. These funds seek to address investors’ capital requirement at a future date. The report provides further insights
When it comes to debt mutual funds the perception of retail investors is that they are risk-free and safe. This is presumed by most retail investors. However, the back-to-back credit rating downgrades of Infrastructure Leasing and Financial Services (ILFS) in 2018, DHFL and Yes Bank in 2019 has compelled investors to change their perception about the safety of debt funds. This year investors have had to alter their viewpoint about return expectation from debt funds. They cannot expect a predictable return from debt funds even through government securities. The returns of long duration funds or funds having higher exposure to long duration papers are in the negative zone. This time it was not credit risk but interest rate risk. All this has certainly been very demoralising for debt fund investors.
Such cumulative events might have led many retail investors to go back to their bank fixed deposits (FD) where they are assured of getting two major things:
1. Assurance of receiving back the invested capital.
2. Getting predictable fixed returns.
But what if we say that you can achieve your financial goals even with target-date debt funds and that too with better returns than your bank FDs, particularly for people in the highest tax bracket? In this article, our effort would be towards helping you understand what are target-date funds, their performance and risk factors, the kind of tax efficiency they provide to investors and how ideal they are for investments.
Understanding Target-Date Debt Funds
Target-date funds or target-maturity funds are like index funds or exchange-traded funds (ETFs) and have been structured in a way that will help you grow assets optimised for a specific timeframe. These funds seek to address investors’ capital requirement at a future date. Hence, they are called target-date. Mostly these kinds of funds are used for various financial goals such as child’s education, retirement, etc. which may occur in the future.
These funds can invest in equity, debt or even have a combination of both. That said, presently in India there are target-date funds that predominantly invest in debt securities. Furthermore, as these target-date debt funds follow an accrual strategy, they try to minimise your interest rate risk by holding the instruments till the target date and further try to avoid any credit risk by investing in government securities and AAA-rated securities of public sector undertakings (PSU).
Working of Target-Date Debt Funds
As the name indicates, target-date funds have a defined maturity. Here the fund passively invests in bonds of a similar maturity that constitute the fund’s benchmark index. When the fund matures, investors get their maturity proceeds that comprises their initial investment along with the returns accrued on them. These funds typically buy securities such as corporate bonds, government securities, state development loan (SDL) bonds or a combination of these, which is in line with their respective benchmark indices. For instance, the IDFC Gilt 2028 Index Fund seeks to invest in the constituents of the CRISIL Gilt 2028 Index.
Speaking about the credit quality, presently the available target-date debt funds invest in government securities, including SDL bonds, which enjoy sovereign i.e. government guarantee. Therefore, such securities carry no credit or default risk and can be deemed safe. Though a notch lower in terms of credit quality, the corporate bonds issued by public sector entities enjoy government backing, in turn lending comfort.
As can be seen from the above graph, the average asset allocation of target-date debt funds is more skewed towards AAA-rated papers of PSUs, followed by government securities and cash.
Performance
Presently there are three kinds of target-date debt funds:
1. Bharat Bond ETF that invests in AAA-rated papers of PSUs.
2. Nippon India ETF Nifty CPSE Bond Plus SDL that invests in AAA-rated papers of PSUs along with SDL bonds.
3. IDFC Gilt Index Fund that invests predominantly in government securities.
In order to understand their performance, it makes sense to check the performance of the index that it tracks. To measure their performance, we have taken respective indices’ data from January 2020 to March 26, 2021. And from this data we would be calculating their three-month rolling returns and standard deviation to understand their risk and return profile.
As you can see, when it comes to returns it is Bharat Bond – April 2023 and April 2030 – indices that performed better as their average three-month returns stood at 2.1 per cent and 2.4 per cent, respectively. This can be attributed to operational twists and various other measures taken by the Reserve Bank of India (RBI) in the period of study. However, this doesn’t mean that Nifty CPSE Plus SDL Bond indices failed to perform. The data for them is quite limited for drawing that conclusion. The same is the case with Bharat Bond – April 2025 and April 2031 – indices.
If we look at the risk from the standard deviation viewpoint, the risk certainly is quite low. In fact, the average standard deviation of funds with similar average maturity in years is higher than the standard deviation of the indices in the study.
Investor Profile
We now come to the question of who should invest in them. This is most suited for those who wish to invest in funds with somewhat predictable returns or those who are in a higher tax bracket and are looking for more tax-efficient alternatives to bank FDs and those who are conservative and comfortable with lower returns. However, if you are an aggressive investor and expect to get some phenomenal returns from them, then you would surely be disappointed. This is because the main intention of these funds (those that are available as of today) is to avoid credit risk by investing in government securities and AAA-rated papers of PSUs. Moreover, they also seek to reduce interest rate risk by playing on accrual strategy rather than duration strategy. Therefore, those who are looking for handsome returns from debt funds can certainly look at credit risk funds or tactically play with the duration funds.
Conclusion
Target-date debt funds do have a capability of providing justice to their intention of reducing credit as well as interest rate risk. Also, their structure helps investor to allocate them to their desired financial goal. These funds can prove to be a boon for even conservative investors, specifically those falling in higher tax brackets as they can now invest in funds having virtually zero credit risk and lower interest rate risk. This in turn aids investor to protect their capital. Therefore, from a capital protection perspective it does make sense to invest in them. However, don’t expect that these funds’ risk is quite similar to that of bank FDs. In fact, purely from a risk point of view, bank FDs still have lower risk compared to these funds. However, if you turn your eyes towards better returns than FDs with lower perceived risk, then surely these are funds that you should look forward to.