How Target Maturity Bond Funds Are Changing The Game

The RBNZ has now entered a rate-cut cycle, joining various other central banks around the world. The dovishness of global central banks has created a positive environment for bond markets and attracted greater attention from investors. Target maturity bond funds are an interesting alternative to direct bond investments or term deposits.

In this blog, we talk to Matthew Winton, Kernel Fixed Interest Portfolio Manager about the benefits of target maturity PIE bond funds and examine their significance within the context of the New Zealand tax landscape.

The following graphs illustrate the performance of the target maturity bond funds against their respective hypothetical bonds and official benchmarks.

It should be noted that the funds show strong performance due in part to the compression of credit spreads.

Target maturity bond funds are particularly useful for clients with passive income needs or a specific financial goal in mind. These funds offer the advantage of maturing with a likely return that aligns with the yield at the time of investment, adjusted for compounding, taxes, and fees.

Initially, Kernel launched three and five-year maturities to give investors access to longer-dated maturities than they might consider with bank deposits.

Find out more about the March 2027 NZ Bond Fund and March 2029 NZ Bond Fund.

There are several benefits to holding target maturity bond funds. These funds provide moderate diversification and exposure to wholesale bonds typically inaccessible to retail investors, plus the advantage of PIE tax treatment. Clients can also enjoy efficient liquidity, with the ability to invest amounts as small as $1, making these funds accessible to a broad range of investors.

Furthermore, professional management of a target maturity bond fund would likely involve ongoing portfolio optimisation, making it more likely to achieve a higher return (before fees and tax) over time, compared with a simple buy and hold-to-maturity strategy typically employed by a direct bond investor.

Competent management of target maturity funds can help partially offset any fees and enhance returns.

Kernel's target date bond funds aim for an A- credit rating, a level that reflects a solid balance of credit risk with yield. At the time of writing, this rating level aligns with entities like Auckland Airport, a business with strong assets and low debt levels.

Whilst it is possible for target maturity funds to own investment-grade bonds with slightly lower credit quality, Kernel aims to offset this by including bonds with even higher credit ratings. Furthermore, these funds aim to hold a duration that is very close to the duration of their respective hypothetical bonds.

The NZ Bond Fund is used within the target maturity funds as a low-cost means of managing the funds’ duration and liquidity. This allows the efficient management of applications and redemptions and consequently a good outcome for investors in these funds.

As these funds approach maturity, they will increasingly invest in the Cash Plus Fund to again provide low-cost liquidity for investors.

Additionally, the target maturity funds participate in new issuances either directly or indirectly via the NZ Bond Fund.

While these funds offer a moderate degree of diversification, they still offer an attractive alternative to direct bond investments, due to their PIE status, which can present favourable tax characteristics for investors in the top tax rate as shown in the table below.

With the trust tax rate increasing to 39% investors across the board are seeking out the benefits of the PIE regime, with tax capped at 28%.

Kernel's approach to managing the NZ Bond Fund is primarily based on a relative value strategy. Although bond markets are generally efficient, the dynamics of the bond market still offer opportunities for fund managers to lock in outperformance relative to the index. This is far less common in equity markets.

For this reason, the fund actively positions towards the best risk/return investments, always with an eye towards risk reduction when the opportunity to profitably exit a position occurs.

Both target maturity bond funds have a 1.5 cents per unit quarterly distribution policy. This is designed to give investors a predictable quarterly income source, much like with owning a direct bond. The funds also offer the option of distribution re-investment.

The funds mature in March of the respective year indicated in the fund name.

Approximately one month out from maturity, the funds will close for applications and redemptions. As the funds get closer to maturity, underlying bonds will mature, and the portfolio will transition to cash and cash equivalents.

In the middle of March, the fund will close, and investors will receive the final net asset value per share, inclusive of any remaining undistributed interest. This gives investors time to roll into new target maturity bond funds or make wider portfolio adjustments ahead of the next financial year.

Globally, central banks are already in or about to enter a rate-cutting cycle. This is positive for the bond market as declining yields lead to short-term gains. The market has priced in significant cuts however the general market environment is still positive.

Kernel's target maturity bond funds offer a compelling option for clients seeking a structured, tax-efficient, and actively managed investment strategy. These funds provide an alternative to direct bond ownership, particularly for those with specific financial goals in mind.

*Fair assumption that fund can maintain the same yield as its hypothetical proxy.. Due to ongoing optimisation of the portfolio it might be possible to achieve a higher running yield.

These examples have been simplified for the purpose of illustrating a point. Other personal or investment factors have not been considered