This week will see the NFO of a target maturity debt fund, that has also been billed as India’s first debt index fund. Open-end target maturity debt funds are a product category that merits serious consideration, and one that we should see a lot more of. However, based on some of the commentary that I have seen in the media (mainstream and social), as well as what I’ve been hearing from advisors and investors, I feel that some of the wider understanding could be enhanced, and expectations tempered. In this post, I want to touch upon a couple of less-talked-about points.
It might be worth mentioning that open-end target maturity debt funds were first launched in India over two decades ago. Back in the day, they used to be referred to as ‘serial plans’. Unfortunately, this category (like some others) didn’t quite take off. Perhaps it was an idea whose time had yet to come.
The first point that I want to bring up is that, conceptually speaking, such a fund doesn’t have to be an index fund or an ETF and even if it is structured as such, it may not be purely passively managed. From what I have gathered, unlike equity index funds and ETFs, it is quite common for bond index funds and ETFs worldwide to not replicate the complete set of index constituents. Instead, they follow what is referred to as a ‘sampling’ approach whereby the fund manager seeks to match the more fundamental characteristics of the index such as credit profile, duration, and yield. To be fair, in India, SEBI has put in guidelines that limit the deviation from index constituents. But it still leaves room for some degree of active bond selection.
As a point of contrast, take the original ‘serial plans’. These were typically single-security gilt funds whose maturity coincided with the maturity of the underlying security. Consequently, despite not being index funds, they were perfectly passively managed. The same can also be said for any fund that follows a hard-coded list of issuers, and a pre-defined credit and maturity profile. Thus, a part of me wonders if the index structure currently in vogue, might just be a way to work around the inflexibility of SEBI’s open-end scheme categorization. Regardless, with the growing interest from investors, advisors, as well as fund houses, it may be worthwhile for SEBI to expand the existing scheme classification to include this category.
The second point that I want to talk about is the predictability of return in these funds, as represented by the yields that are reported. No doubt, this is a prominent reason to invest in these funds. However, investors need to be careful in relying upon the disclosed yield. For one, there is the question of how the yield might be impacted if there are large flows into or out of the fund. For another, there is the extent of the gap between the maturity of the fund’s underlying securities and the actual maturity of the fund. As an example, in the case of one existing fund, I noticed that around 10% of the portfolio is scheduled to mature 7 months or more, before the actual maturity of the fund. As and when those bonds mature, it is a moot question as to whether the fund will be able to earn the same yield as what it is getting on those bonds today.
In this context, it might be worth looking at the evidence shared by BlackRock in the US, with respect to its target maturity iBonds ETFs that have matured. Among other things, it shows the difference between the initial net yield and the final return that investors got. So far, the difference across all matured funds has ranged from +0.19% pa to -0.30% pa. In absolute terms, that may or may not seem much but when seen relative to the yields (and the time horizon), that is certainly not a small difference. For example, one of its ETFs started off in December 2014 with a net yield of 2.64% pa. When it matured 6 years later, the total return to investors was 2.35% pa.
As a side note, I don’t know what to make of the fact that SEBI doesn’t allow fund houses to offer any indicative yield on FMPs yet it seemingly has no issue with the disclosure of yields on open-end target maturity funds. All things equal, FMPs offer a more predictable return than these funds.
