fund call. Why you should buy SBI Magnum Constant Maturity Fund now

After charting a vertical climb from 5.8 per cent in July 2020 to 7.6 per cent in June 2022, the yield on the 10-year government security has cooled off slightly to 7.4 per cent now. Bond markets were earlier convinced about sticky inflation and a series of further rate hikes by the RBI. But the recent correction across the commodities pack, on the back of global recession fears, is causing markets to rethink the length and steepness of the ongoing rate hike cycle. It is hard to say which way both rates and inflation may move from here.

A 7.4 per cent yield on the 10-year gilt presents a good level for long-term debt investors to lock into the safest bond in the market. Taking the mutual fund route to invest in this g-sec can fetch you compounding benefits from interest accruals, while ensuring efficient taxation of your final returns. Ten-year constant maturity funds are always invested in either the prevailing 10-year g-sec or multiple g-secs with maturity that averages to 10 years, in order to replicate the yield and price performance of the benchmark gilt. These passive funds also charge lower expenses than actively managed gilt funds.

Navigating rate risk

The key reasons why ordinary debt investors shy away from investing in long-term gilt funds that own them, is their volatile returns from year-to-year and the possibility of losing money in them.

Gilt funds carry no credit risk. But when interest rates in the market rise, the prices of older bonds in the market sink. The longer the maturity of the bond, the more the battering it takes from rate increases. Funds that own 10-year g-secs are highly susceptible to such declines, because of their long tenure and high price sensitivity. If you time your entry into 10-year constant maturity funds to the bottom of a rate cycle, you can face short-term NAV losses if rates rise from your entry point.

But ‘short-term’ is the key word to note here. If you remain invested in a constant maturity gilt fund beyond two-three years, the probability of losses from rate risk shrinks. The steady interest accruals smooth out your returns and make up for the losses from rate movements.

A rolling return analysis of SBI Magnum Constant Maturity Fund (Regular plan) over the last 15 years shows that the fund’s worst losses for a six-month holding period were 4.4 per cent and for a one-year holding were 3.34 per cent. For investors who held the fund for three years, there was no instance of a negative return. Over three-year rolling periods, the fund averaged 8.68 per cent CAGR, with a minimum of 3.13 per cent. For five years, the minimum return was 5.36 per cent and the average 8.64 per cent. If you held for 10 years, matching your horizon to the fund’s maturity, your minimum returns were as high as 7.54 per cent while the average was 8.83 per cent. Going forward, you should not expect constant maturity funds to repeat their high yields of the past, as market interest rates are likely to rule much lower. But long-term returns of 7-7.5 per cent should be possible given current rate trends.

Timing your entry

The above data shows that holding your investments in constant maturity funds for five years plus reduces the possibility of losses from them. But how do you deal with the volatility in returns? To ensure that you do earn reasonable returns from a 10-year constant maturity fund, it is necessary to time your entry right.

In stock markets, you improve your shot at high returns when you buy into equity funds when stock prices are beaten down. The same logic applies to bonds (or gilts) too. You improve your chances of good returns when you buy into long-term gilt funds when gilt prices are beaten down. This essentially means that the best time to buy long-term gilt or constant maturity funds is when market yields have risen sharply, and the past returns from such funds are poor or negative. Most retail investors do exactly the opposite and buy them when past returns are high.

Why buy

As buying into current yields will earn you interest accruals at over 7 per cent, this appears a good time to enter

Constant maturity funds were sporting double-digit returns in December 2008 after a sharp fall in the g-sec yield from over 9 per cent in August 2008 to about 5 per cent. But investors who bought them in December 2008 made just a 6 per cent CAGR in the next five years and 8 per cent over the next 10 years. Investors who bought when market yields were at 9 per cent in August 2008, earned 7.4 per cent over the next five years and 8.5 per cent over the next decade.

Why now?

Given the uncertainties prevailing around the inflation and rate outlook today, there’s no saying if Indian g-sec yields will get to the 8 per cent levels of the past, or top out much before. Catching the top of a rate cycle is just as difficult as catching a bear market bottom. As buying into current yields will earn you interest accruals at over 7 per cent, with the probability of price gains, this appears a good time to enter. There are four open-end constant maturity gilt funds and one ETF available to play this opportunity. But SBI Magnum Constant Maturity Gilt Fund appears a good bet owing to its 10-year plus track record and good performance across rate cycles.

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