After a series of rate hikes that have taken the repo rate up by 250 basis points until April 2023, interest rates in India seem to be on a long pause. From here, government bond yields look unlikely to rise significantly, but can decline in future. This makes it a good time to buy debt funds which invest in medium to long duration bonds. Should interest rates fall from current levels, investors can benefit both from interest receipts and capital gains from rising bond prices.

For those seeking a relatively safe medium duration investment at low cost, passive gilt funds or Exchange Traded Funds (ETFs) that invest in g-secs (government securities) with 5-year constant maturity are a good choice.

Why g-sec funds

Compared to the yield of about 7.1 per cent on the 5-year g-secs, AAA-rated corporate bonds with similar maturity currently offer a yield of about 7.7 per cent, while AA-rated bonds offer 8.5 per cent. But both corporate bond funds and credit risk funds are actively managed categories where portfolio duration is difficult to predict.

While these funds may offer you a higher yield presently, you cannot be sure of them maintaining a medium duration throughout your holding period. Today, the average portfolio maturity of most corporate bond funds and credit risk funds varies between 1 and 4 years. This can change in future based on where these funds find investment opportunities. A 5-year g-sec fund in contrast will maintain a constant exposure to the 5-year g-sec, helping you benefit from rate declines.

Being actively managed corporate bond and credit risk funds also come at relatively high annual fees. The average Total Expense Ratios (TERs) on the direct plans of corporate bond funds and credit risk funds stands at about 0.80 per cent currently, while that on regular plans stands at about 1.5 per cent annually. In contrast, Exchange Traded Funds and open-end funds investing in 5-year g-secs are available at TERs of 0.09 to 0.23 per cent per annum.

5-year versus 10-year

Within passive gilt funds, 10-year constant maturity funds have a longer vintage than 5-year ones. The 10-year g-sec is the benchmark bond for the Indian market and tends to feature high liquidity and activity. Constant maturity funds ETFs that invest in the 10-year g-sec therefore tend to be more sensitive to rate swings than funds with 5-year maturity. Given the longer tenor, 10-year funds are also likely to deliver higher gains from rate declines than 5-year funds.

But in India, the yield differential between 5-year and 10-year g-secs tends to be quite low, at 10-20 basis points at most times. At present, for instance, the yield on the 5-year g-sec is at 7.08 per cent while the 10-year g-sec yield is at 7.18 per cent. Investing in the 5-year gilt therefore offers almost similar interest accruals with lower rate risk. In case interest rates rise from here or stay on hold, investments in 5-year g-secs will match or better the returns from investments in 10-year gilts.

Constant maturity versus target maturity funds

With many fund houses now running target maturity debt funds, there are a number of index funds which invest in gilts, State Development Loans and PSU bonds with maturity dates in 2028 too. Such funds may offer a higher yield than funds that invest only in 5 year g-secs. However, given that these funds are set to mature on a fixed date five years hence, they follow a roll-down strategy. That is, they will steadily reduce their portfolio maturity from the current 5 years, as their maturity date approaches, so that they can wind up and return money to investors. Such funds do not carry interest rate risks. But on the flip side, neither do they deliver capital gains from falling rates.

Fund options

Investors wishing to buy 5-year gilt funds have the choice of three ETF products and one Fund of Funds in this space. ICICI Pru 5-year benchmark G-sec ETF (TER 0.20 per cent), Motilal Oswal 5-year G-sec ETF (0.23 per cent) and Nippon India ETF Nifty 5-year G-sec (0.09 per cent) are the exchange-traded funds. As ETFs need to be bought from the exchanges, investors need to ensure that their purchase price on ETF units is close to the last declared Net Asset Value (NAV). This can be checked here:

Of the three ETFs, Nippon’s (GILT5YBEES) features better trading volumes and also comes at the lowest annual cost. But investors who do not want to take any chances on liquidity or prices straying off the NAV, can consider Motilal Oswal’s Fund of Funds product investing in the 5 year g-sec ETF from the same AMC. It has a reasonable TER of 0.13 per cent on the direct plan.

Why 5 yr g-sec funds
TERs of < 25 bps 
Fixed duration
Yield close to 10 yr
 Possible duration gains