NFO: MOSL 5-year G-Sec ETF: Attractive post-tax returns, but is it risk-free?

Motilal Oswal AMC has launched its 5-year G-Sec ETF (exchange-traded fund). The ETF will track the Nifty 5- year benchmark G-Sec Index which comprises most actively traded government bonds with a residual maturity of 4-6.5 years. The index is reviewed every month.

With interest rates at historical low levels, fixed-income investors have been left wanting for better returns.This is especially so for those in the higher tax brackets.

For such investors, debt funds score over other fixed-income products on the tax front. Gains on debt funds held for more than three years (long-term capital gains) are taxed at 20 per cent with indexation benefit. Interest on fixed deposits is instead, taxed at an individual’s income-tax slab rate. Like other debt funds or ETFs, the Motilal Oswal 5-year G-Sec ETF (MOSL ETF) too enjoys this tax advantage.

Returns

The Nifty 5-year Benchmark G-Sec Index, which the MOSL ETF will track, has on an average outperformed the Nifty G-Sec indices of other durations, both over 3-year and 5-year periods, based on rolling returns (rolled daily) since inception 20 years ago. The Nifty 5-year Benchmark G-Sec Index has also had greater instances of 3-year and 5-year returns of over 8 per cent and 10 per cent, respectively, compared with the other duration Nifty G-Sec indices.(See table)

According to the fund house, the tracking error (deviation of ETF return from the index return) for this ETF will largely equal the expense ratio of the 0.22 per cent.

The Nifty 5-year Benchmark G-Sec Index has also shown lower downside risk. This is indicated by its lower drawdowns (percentage fall in the index value each day relative to its previous peak) vis-à-vis other comparable indices, except for the Nifty Short Duration G-Sec Index in the last 20 years.

The relatively better returns and lower volatility of the Nifty 5-year Benchmark G-Sec Index may offer some comfort.

Risks

While a gilt fund or ETF has no credit and liquidity risk, it is exposed to interest-rate risk . Returns of a gilt fund or ETF come from the interest received on the G-secs held and the changes in the prices of these G-secs. Depending on how interest rates move, G-sec prices can rise (fall), with the resultant capital gain (loss) impacting the fund NAV. When interest rates are falling, the price of existing G-secs rise as they are in greater demand versus the new lower interest bearing G-secs. The reverse too holds true.

With several cuts by the RBI since February 2019, the repo rate has come down from 6.25 per cent to 4 per cent now. Many gilt funds have posted impressive 1-year returns of 10-13 per cent as a result. This, maynot sustain. The RBI has reiterated it will maintain an accommodative stance at least during FY21 and into FY22, but given the low interest rates, the possibility of further rate cuts (G-sec price appreciation) may be low.

Besides, in an actively managed gilt fund, the fund manager takes active duration calls (modify the composition of G-sec holdings of different maturities in the fund) to benefit from the changing rate cycle. But a passively managed fund will simply track its benchmark index. So, investors may want to time their entry. The current yield on 5-year G-secs is 5.075 per cent. A possible uptrend in rates can chip away at the return.

As with any ETF, investors can wait to see if trading volumes are sufficient. If not, the ETF units can trade at a market price different from the NAV. The NFO closes on December 2.