Constant maturity gilt mutual funds can be good bets in falling interest rate scenario

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Investors betting on softening interest rates typically invest in gilt funds or long-term debt funds. These funds invest in instruments with longer maturities that benefit the most in a falling interest rate environment—interest rates and bond prices move in opposite directions. Among long-term debt and gilt funds, constant maturity gilt funds have fared better in the recent past.

A traditional gilt fund invests in a mix of government bonds with varying maturities. The fund manager shifts the portfolio towards longer or shorter maturity instruments based on his outlook of the prevailing interest rate scenario. If he expects rates to soften, he may shift a large part of the fund’s corpus to government securities with 15-20 year or higher maturities. Conversely, if he expects the rates to rise, he may invest a higher portion in government bonds with 7-10 year or lower maturities. By actively shifting the duration of the portfolio, the fund manager seeks to make the most of interest rate movements.

However, this leaves the gilt fund vulnerable to the calls of the fund manager. If the fund manager shifts the portfolio duration too high but rates stay stagnant or inch upward, the fund’s returns will be hit hard. Similarly, if he takes a conservative stance and lowers the fund duration just before an interest rate cut, the fund’s gains will be limited.

A constant maturity gilt fund, however, invests in a mix of government bonds with maturity of around 10 years. Whatever the interest rate scenario, the fund’s portfolio duration is maintained at 10 years. Unlike traditional gilt funds, it takes a much more passive approach towards government bonds. It removes the element of human error—the risk of wrong duration calls by fund managers.

“The constant maturity gilt fund will not try to time the market and, to that extent, the chances of the fund manager’s calls going wrong are few,” says Vidya Bala, Head, Mutual Fund Research, FundsIndia.

R. Sivakumar, Head, Fixed Income, Axis Mutual Fund, reckons that constant maturity gilt funds are an efficient way to get exposure to the most liquid part of the bond market. “If you seek pure-play G-Sec participation, this index-like structure with low costs is a good investment proposition,” he says.

Unlike a traditional gilt fund, there is certainty about where a constant maturity gilt fund will invest at any given time and the risks it takes. Its returns will also not vary as much as a gilt fund’s that actively manages the duration of the portfolio. There is huge variation in the positioning of gilt funds at any given time.

Constant maturity gilt funds have fared better among long-term debt funds
They have outperformed their traditional peers over 1- and 3-year periods.

Fund Expense Ratio (%) 1-year return (%) 3-year return (%)
DSP 10Y G-Sec Fund 0.47 8.57 6.77
ICICI Prudential Constant Maturity Gilt Fund 0.33 10.39 8.29
IDFC Government Securities Fund – Constant Maturity Plan 0.48 12.41 9.05
SBI Magnum Constant Maturity Fund 0.64 9.71 8.9
Traditional gilt funds average 1.14 8.39 7.1
Long duration debt funds average 1.12 8.71 7.77

Source: Value Research. Data as on 26 April

For instance, currently, there are some gilt funds with average maturity of less than 3-4 years, some with maturity of more than 10 years and several others fall in between. Constant maturity gilt funds maintain a stable maturity profile. If the investor ends up holding the fund for a similar time horizon, the returns will be in line with the G-Sec yield for that period.

Experts reckon this is ideal for investors who want to benefit from a rate softening regime, but want to avoid the risk of active management. “It makes for a much less volatile offering than typical long-duration schemes or even dynamic bond funds,” says Bala. Over the past one year, these funds have generated a return of 9.83% compared to 8.39% given by traditional gilt funds. They have also outperformed their traditional peers over a three-year period.

Like any normal gilt fund, investors should have a positive interest rate view to consider investing in these funds. While these funds don’t carry fund manager risk, they come with market risk—the risk of adverse movements in interest rates. As these are long-term funds, they will be quite sensitive to changes in interest rates.

Currently, while rates have been on the ebb, there is very little certainty on a soft interest rate regime continuing in the near term. Against this backdrop, while a gilt or long-term fund may protect value by lowering duration, the constant maturity gilt fund may take a hit. Sivakumar argues, “While the RBI is still on the rate cut path, the longer term interest rates remain fairly anchored for now. Increasing duration may not necessarily work in investors’ favour.”

[“source=economictimes.indiatimes”]