Target maturity funds are fine but beware of reinvestment risk

TMFs provide some degree of predictability of return for those who remain invested till the maturity of the scheme. For example, Bharat Bond ETF – April 2031 – launched in July 2020 and replicates the portfolio of Nifty Bharat Bond Index – April 2031 – has a current yield to maturity (YTM) of 7.7%. This means, a person investing in the fund now, if held till maturity, can earn a return of 7.7% annually.

The risk that TMFs may not deliver the expected returns at the time of investment can arise primarily due to two reasons: One is tracking error – the deviation in TMF returns from the benchmark due to the position of the portfolio at different points in time. The second is reinvestment risk – interest income earned by the portfolio may be reinvested at a rate lower than the rate of return at the time of investment.

Please check the tracking error before investing. Funds with low tracking error are comparatively better. Here, we write down what investors should know about reinvestment risk and how it can impact overall returns under various scenarios.

reinvestment risk

TMFs are not very attractive in a rising interest rate scenario. This is because investors tend to lock in lower interest rates and this can have an adverse effect on overall returns, especially when interest rates are expected to rise in the future.

Currently, experts are of the view that we are nearing a peak in the interest rate cycle given the macro-economic conditions. In India, the 10-year G-Sec instrument yield has increased from 5.8% in mid-2020 to around 7.3% now. TMFs with residual maturity of 4-5 years currently offer YTM of 7.5-7.7% per annum at the end of February.

In this scenario, holding the investment in TMF till maturity is seen as a good opportunity to lock in the higher projected YTM.

“The disadvantage of the YTM formula is that it assumes that each subsequent cash flow (interest income) is also reinvested in the principal yield, which is never the reality,” said Vishal Chandirmani, chief operating officer at TrustPlutus.

In simple terms, the underlying bond continues to pay interest, which gets reinvested at the rates prevailing at that time and not the return at the time of investment. If we are already at the peak of an interest cycle, it is likely that subsequent cash flows will be reinvested at lower rates. This will reduce the expected yield from the investment.

Arun Kumar, head of research at FundsIndia, said the impact of reinvestment risk depends on how low the return is at the time of reinvestment versus the initial return.

For example, a TMF matures in approximately 9.5 years and offers 7.5% YTM at the time of investment. If all future cash flows are assumed to be reinvested at a lower interest rate of 6.5% (about 100 basis points, or bps, lower), the actual return would be 7.3%, 20 bps lower than the original YTM. In the worst-case scenario of future yields falling to 5.5%, the return on investment would be around 7.1%, 40 bps lower than the original YTM of 7.5%. (A basis point is one hundredth of a percentage point.)

This suggests that the effect of reinvestment risk is not significant. The above calculation assumes that all future cash flows will be invested at the same rate, which may not be the case, but gives a reasonable idea of ​​the impact of reinvestment risk. Also, the longer the tenure of the TMF, the higher the reinvestment risk.

“For a TMF of 3-5 years, even if the reinvestment is at a lower yield (around 100 bps less than the current yield), the impact on returns may be just 10-20 bps,” said Kumar.

Note that, on the other hand, if interest rates rise, future cash flows will be reinvested at a higher rate. In that case, one can expect to earn at least the expected YTM at the time of investment, if not more.

what should you do?

To reduce the reinvestment risk that comes with TMFs, one can consider investing in funds maturing in 3-5 years as compared to long-term TMFs of 10 years or more, suggested Kumar.

Not only this, currently the tenure of 3-5 years is also considered to be a good place among the many maturity brackets available. For bonds with longer durations, the increase in yield from one period to the next is not significant and the risk return is not favourable.

Kumar also suggested that investors take 20-30 basis points less than the estimated YTM at the time of investing in TMFs. This can help in managing expectations better, he said.

Almost all TMFs invest in relatively safe instruments such as G-Secs, State Development Loans (SDLs) and AAA-rated paper, due to which the credit risk of these products is low. In addition, holding till maturity also reduces the interest rate risk, resulting in mark-to-market losses on investments due to interest rate fluctuations in the economy.

Thus, investors who have financial goals that match the tenure of these funds can consider investing in TMFs over fixed deposits, given the tax efficient structure of the former.

Returns from TMF after indexation are taxed at 20% if held for more than 3 years. Short-term capital gains from TMFs are taxed at the individual’s slab rates – similar to the tax treatment of interest earned from bank fixed deposits (FDs).

SEBI-registered investment advisor Vishal Dhawan also pointed to the risk of future fresh inflows into TMFs invested at low rates. “Future cash flows from new investors, invested at low returns, may drag down the overall returns of the fund. The only way to avoid this is by investing in close-ended FMPs (Fixed Maturity Plans), which invest in any new investment after the subscription period. Does not take flows. Having said that, in the trade-off between liquidity and marginally higher returns, investors are suggested to go for open-ended TMFs,” said Dhawan.