Interest rate risk is absent, if funds are held till maturity.

There is consensus that interest rates are going to inch up gradually. It is a matter of time. When rates rise, your mutual fund investments are adversely impacted. The reason is simple: when rates rise, bond prices decline. While there is interest accrual in all debt funds, movement of bond prices may be favourable or adverse, adding to or takes away from the interest accrual in the fund. In such a situation, target maturity debt funds (TMFs) are useful investments. The balance portfolio maturity of the fund comes down gradually as the fund approaches the target maturity, which in turn reduces volatility.

What is maturity roll-down?

If you buy a bond and hold it till maturity, then the potential volatility also comes down progressively. There is a concept of modified duration of a bond or a bond fund, which is also known as the multiplier. When interest rates move up or down, the impact on prices and, hence, your returns, is gauged by this multiplier. Lower the maturity of the bond or the bond fund, lower is the modified duration, and lower is the volatility. In bond funds, progressively lower duration can be achieved through: (a) close-ended funds such as Fixed Maturity Plans (FMPs), or (b) TMFs, which are in the nature of either Index Funds or ETFs. FMPs are now diminishing in popularity, as there is lack of liquidity prior to maturity. In Index Funds, there is regular purchase/redemption of units. For ETFs, the liquidity is at the exchanges, but you require broking and demat accounts. There may be brokerage / transaction costs involved as well.

Construct of TMFs

There are specific benchmarks constructed for every TMF. This is done after a consultation process between the AMC floating the product and the benchmark provider. The benchmark provider in most cases is the NSE; sometimes, it is CRISIL. The TMF replicates that benchmark. The fund matures and the benchmark is extinguished at the same time, which is the target maturity date. As there is a defined maturity date, with every passing day, the residual or remaining maturity comes down, which is the concept of maturity roll-down mentioned earlier.

Target Maturity Index Funds

-IDFC Gilt 2027 Index Fund and Gilt 2028 Index Fund follow CRISIL indices. Their portfolio comprises Government Securities.

-ICICI Prudential PSU Bond plus SDL 40:60 Index Fund – Sep 2027: this is an NFO in September 2021; portfolio will comprise 40 percent AAA rated PSUs and 60 percent SDLs.

SDLs or State Development Loans are securities issued by State Governments and are classified as sovereign

Target Maturity ETFs

-There are Bharat Bond ETFs of various maturities; April 2023, April 2025, April 2030 and April 2031. Portfolios of these funds comprise AAA rated PSU bonds, which are of very high investment credit quality.

-There is Nippon India ETF Nifty CPSE Bond Plus SDL-2024 and ETF Nifty SDL-2026. The portfolio of these two funds comprise State Government securities, known as State Development Loans (SDLs), which are of even better credit quality than  AAA rated PSU bonds.

Benefits of TMFs

The advantages of TMFs are: (1) credit risk is minimal, next to nil, as investments are in SDLs or AAA rated PSU bonds or G-Secs; (2) Interest rate risk or volatility risk absent, if it is held to maturity, as the product matures and money flows back to the investor; (3) Tax efficiency is a significant advantage. For a holding period of three years or more, like any other open-ended debt fund or FMP, TMFs are eligible for indexation. The net capital gains after the indexed purchase cost is subject to tax at 20 percent. Effectively, by virtue of indexation, the tax rate becomes negligible. You need not hold till maturity for indexation benefit, it has to be held for three years or more; and (4) Liquidity is adequate, unlike for FMPs.

There are multiple maturities of TMFs available; choose funds as per your cash flow requirements. Though all TMFs are liquid, index funds are better than ETFs as liquidity is with the AMC in the normal course. As an illustration of tax indexation benefit, for an investment made now, with maturity in 2027, you get indexation over six financial years. As per the current portfolio construct, the portfolio YTM of ICICI Prudential PSU Bond plus SDL 40:60 Index Fund – Sep 2027 (as per index) is 6.28 percent and that of IDFC Gilt 2027 Index Fund is 5.88 percent.

Source: https://www.moneycontrol.com/news/business/personal-finance/how-target-maturity-funds-can-be-good-investments-during-rising-interest-rates-7489571.html