Mutual Funds

A golden egg if you can wait it out

Aarati Krishnan | Updated on January 24, 2018 Published on June 20, 2015

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These gilt funds maintain a maturity of about 10 years, gain from falling rates and come at a low cost



Would you buy a government bond that offers 8 per cent interest for 10 years, with lower tax on your returns than your income tax slab rate? Many investors would.

Now, mutual fund houses offer debt schemes that buy 10-year government securities and simply sit on them to make returns. These are named Constant Maturity Funds.

Currently, DSP BlackRock Constant Maturity 10-year G-Sec, Axis Constant Maturity 10 year, ICICI Prudential Constant Maturity Gilt and Tata Mid Term Gilt Fund are funds in this genre. You should consider them if you’re looking for long-term debt options and fall in the higher tax bracket.

How they work

Normally, debt mutual funds pack their portfolios with G-Secs of varying terms, and corporate bonds. To deliver above-benchmark returns, they raise the average maturity of the bonds in their portfolio. Or, they may stray off G-Secs and buy lower-rated instruments.

Constant Maturity Funds are open-end debt funds that do none of the above. They simply make sure that their portfolio is invested in G-Secs with an average maturity of 10 years at all times. G-Secs carry no credit risk (the government, unless it is in Greece, won’t default). They do carry interest rate risk. But if you expect the RBI to steadily cut its interest rates over the next two-three years, taking on this risk can work to your favour.

As market rates fall, 10-year G-Sec prices will rise, thus adding to the NAV gains on the Constant Maturity Funds.

Why only 10-year G-Secs? Well, 10-year G-Secs are the most liquid and sought-after instruments in the relatively illiquid Indian bond market. Open-end funds may receive both inflows and outflows, and can easily buy or sell 10-year G-Secs to adjust to these flows.

Not completely passive

But why should you pay a fund manager to just buy 10-year G-Secs and sit on them? Well, Constant Maturity Funds are somewhat passive funds, but they do not actually own just one security. Instead, most funds usually construct a portfolio made up of G-Secs with 8 to 12-year maturity, so that they average out to 10 years. While 10-year G-Secs are much in demand, those with slightly differing maturity, such as eight or nine or 12 years may be available at much lower prices. Therefore, Constant Maturity Funds use such pricing anomalies to improve your returns.

What returns to expect

Unless interest rates fall, you should expect such funds to deliver nearly the same returns as the current yield on the 10-year G-Sec. If the 10-year G-Sec is currently offering a yield of 7.7 per cent, and interest rates don’t budge, you can expect an annual return of 7.5 per cent or so (post-fees) from such funds.

If, however, interest rates do drop over the next two-three years, you can expect the fund’s NAV to appreciate, with a kicker to the fund’s returns. Returns can get to double digits if RBI slashes rates by 50 basis points or more.

Why go for these when bank FDs can give you 8.5 per cent? Well, if you fall in the 20 or 30 per cent tax brackets, your FD interest is subject to tax at your slab rate.

Therefore, even if your three-year deposit gives you 8.5 per cent a year, that return will stand reduced to 6.7 per cent or 5.95 per cent, post-tax.

However, Constant Maturity Gilt Funds allow you to claim indexation benefits on your capital gains if you hold them for three years or more. Therefore, if inflation rates average 5 per cent for the next three years and your fund earns 8 per cent, you will be left with a post-tax return of 7.3 to 7.6 per cent.

But if you exit these funds within three years, you will pay tax at your slab rates.

Costs

Actively managed debt funds can give you better returns, if the fund manager gets his calls right. But these funds usually charge big fees (1.5-2 per cent). But Constant Maturity Gilt Funds, because of their passive management, carry expense ratios of 0.40-1 per cent a year. So, they’re a cost-effective way to play on long-term gilts.

When you should buy them

Constant Maturity Funds can deliver low or negative returns if interest rates rise. Buy them if you believe that the RBI will cut its policy rates by 50-75 basis points from here and that market yields will follow suit.

Published on June 20, 2015
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