After falling sharply between February and May this year, yields on long-term bonds in India have been spiking up again. The market bellwether – the 10-year government of India security – is now back at 7.25% after dipping below the 7% mark in May. The recent spike presents a good opportunity for debt investors to lock into 10-year constant maturity gilt funds. These are passive funds that are always invested in government of India bonds – either with 10-year residual maturity or averaging out to 10-year residual maturity.
Rates near the top
Unlike actively managed gilt funds, constant maturity gilt funds are passive funds where the investor is expected to time his or her investments to improve returns. 10-year constant maturity gilt funds are best bought when rates are closer to the top of a rising cycle. We think that interest rate in India are pretty close to the top in this hiking cycle.
The Monetary Policy Committee (MPC) considers three variables to decide on its rate hikes and this is where we stand on each of them.
- Inflation: CPI inflation rates are abating after a recent monsoon-induced flare-up. The current rate hiking cycle was flagged off because India’s Consumer Price Inflation (CPI) rate shot up to over 7.7% in April 2022, fuelled by supply disruptions caused by the Russia-Ukraine conflict. The lifting of those disruptions over the next few months, taken with rate hikes, saw inflation cooling to 4.31% by May 2023. After hiking the repo rate by 250 basis points from 4% to 6.5% between May 2022 and April 2023, India’s Monetary Policy Committee (MPC) has been on pause since then.
The recent months of June, July and August 2023 have seen inflation flare up again to 4.87%, 7.44% and 6.83% respectively. But this bout of inflation has been triggered by an erratic monsoon impacting sowing of cereals, pulses and vegetables. The MPC has taken the view that such spikes tend to be transitory and remained on hold.
In July, RBI imposed an incremental CRR (cash reserve ratio) of 10% on banks to stay in place until October 7, to mop up excess liquidity. The Government on its part cracked down on hoarding, curbed exports and made open market sales of vegetables, pulses, rice etc, which has helped to quell food inflation.
The monsoon too has seen a late pickup from September which should see improved output and a better rabi crop. Recently, global oil prices have been heating up again, moving close to the $90 mark posing a risk to CPI. But forecasters expect India’s inflation to remain below 6% for FY24 (World Bank – 5.9% and RBI 5.4% for FY24).
- Growth: GDP growth has been losing momentum after posting a big surge post-Covid. With the pent-up demand post Covid wearing off and also the low base effect, quarterly GDP growth has moderated from a high of 21.6% in Q1FY22 to 7.8% in Q1 FY24. The last three quarters have seen muted readings of 6.2% (Q2 FY23), 4.3% (Q3FY23) and 6.1% (Q4 FY23). These numbers are low enough to worry MPC members about the impact that rate hikes so far can have on growth. RBI is unlikely to be keen to hurt growth or sentiment through rate hikes in an election year.
- Global rates: RBI may not explicitly say it, but MPC rate actions also need to factor in changes in the global risk environment and rate cycles. Narrowing differentials between Indian interest rates and interest rates in the West, particularly US have in the past caused big FPI outflows, destabilised the Rupee and forced India to hike rates to make the country attractive to FPIs (egs 2013). In recent weeks, the US bond market has been seeing a big selloff, which has seen the US 1 year treasury yield top 5.5%. Such yield spikes in the past have seen emerging markets sell off. This wild card factor can force the MPC’s hand and trigger further rate hikes.
But we believe that hikes (if any) beyond another 25 or 50 basis points are unlikely. For one, this time around, there’s uncertainty about how FPIs will react to US treasury yields spiking, as the US government is sitting on unmanageable levels of debt while emerging economies like India are not.
Two, the recent inclusion of Indian government bonds in the JP Morgan Global Bond Index (Read about its impact of India’s inclusion ) can spark demand for Indian g-secs from passive FPIs and partly offset pullouts by active investors.
Why constant maturity funds for this debt strategy
Even assuming Indian rates have about 25 or 50 basis points of upside left in this cycle, this is a good time for debt investors with a 5-year plus horizon to buy into 10-year constant maturity gilt funds. Primeinvestor has buy ratings on SBI Constant Maturity Gilt Fund and ICICI Pru Constant Maturity Gilt Fund and you can consider either of these funds for investment. SBI Constant Maturity is part of Prime Funds.
The rationale for this call is as follows:
# 1 Timing helps
Like any other debt category, constant maturity debt funds earn their returns from interest accruals on their gilt holdings and price gains (or losses) on market prices of gilts. Entering 10-year constant maturity funds helps you to bump up your returns from both sources. When you invest in a 10-year gilt fund when market yields are at 7% instead of say 6%, the interest accruing to your NAV each year will be higher.
As interest rates are already close to their cyclical high, there’s also more likelihood of NAV gains from a fall in rates (as the next cycle comes up). If you believe that interest rates in India, like those in developed markets will only go South in the long run, you should lock into rates above 7% whenever such opportunities crop up. This is best done through 10-year constant maturity gilt funds.
# 2 Misfired active calls
Constant maturity gilt funds are an alternative to actively managed gilt funds, where fund managers actively vary the duration of gilts they own based on their own rate outlook. So why do we prefer them? Well, because active calls by gilt fund managers can go wrong. If they take an over-conservative view on rates, the fund may remain invested in short-medium duration gilts and fail to capitalise on falling rates.
If they take an aggressive view and own very long-term bonds, the fund can suffer significant NAV erosion if rates rise further. Both the direction and the timing of this call need to be right for active gilt funds to outperform the underlying security. A constant maturity fund simply owns the 10-year g sec at all times, side-stepping the risk of wrong active calls.
# 3 Low TER
Expenses often eat away a significant chunk of your returns from debt funds. Being passive products, 10-year constant maturity gilt funds have far lower TERs than active gilt funds. The two funds we recommend – SBI and ICICI Pru Constant Maturity Gilt Fund have TERs of 0.3% and 0.23% respectively against 0.40% to 0.97% for actively managed gilt funds.
Risks
10-year constant maturity gilt funds carry duration risk – the risk that a sharp rise in interest rates will trigger a fall in the NAV of your fund. Such funds are therefore not suitable for the typical fixed income investor who looks for steady NAV gains or regular income from a debt fund.
This category is among the most volatile ones in debt, because your returns are highly sensitive to changes in market interest rates. If market rates rise significantly after you buy the fund, you can make losses in the short run and lower NAV returns in the medium term too.
However, a rolling return analysis shows that the NAV hits to these funds from rising rates are usually made up by interest receipts, if the funds are held for 3 years or more. The following rolling returns, using our rolling returns calculator, show that the funds we recommend have not had any loss-making periods on a 3-year rolling return basis in the last 8 years, despite this period seeing a rising rate cycle. The average rolling CAGRs of 8% plus show that even if an investor mis-times his or her entry into these funds, stretching the holding period can lead to healthy returns over time.
29 thoughts on “Prime debt strategy: Time to enter this duration category”
WHy is the 10 yr Passive Fund recommended and Not the Active Gilt funds of SBI and ICICI? Are we not better off leaving it to the discretion of the fund manager by choosing their active Gilt fund?
In this strategy, we’re specifically taking a call on the 10-year duration. Gilt funds that change maturities make them unpredictable for such a strategy; if they change maturities to being short-term for example, any gain from bond price rallies would be much lower than long. – thanks, Bhavana
I have a basic question about the fund mechanism.
In order to maintain the average 10 year maturity, wouldn’t the fund have to buy newer long term bonds as time passes? The new bonds will have a lower coupon if the rates go down.
Will this not lead to the returns being lower than the current yield?
What am I missing here?
They need not be new bonds. They can be 15, 20, 25, 30 year bonds that have residual maturity of 10. Vidya
Thanks Arti,
There are two recommendations on your MF recommendation page, one is SBI Magnum gilt fund and the other is SBI Magnum constant maturity fund, both have buy recommendations but one is rated 5 and the other is rated 3. What is the difference in these two fund?
The girl fund is active and may change the maturity of the portfolio based on the fund managers rate view. The constant maturity fund will always maintain a 10 year maturity.
Thanks Aarti, so the buy recommendation is on the 10 year fund? or is it on the actively managed gilt fund? Getting a bit confused here
We have given only the constant maturity fund in that report 🙂 Vidya
I understand that if one locks in 10yr constant maturity guilt fund at this point of time
1. He should remain invested for 10yrs no less no more for maximum gain.
2. Hence this will be suitable only if you are not looking for regular interest income.
If one holds on as above what return one can expect?
If you can clarify the above points.
Regards and Thanks
Dipak
Over 10 years the funds returns should be about equal to the current yield minus TER. But the funds can manage a higher return even over shorter periods based on whether rates fall after you buy the fund.
hi,
Can we enter in these funds and exit as normal debt funds before maturity say between 3-5 years.
thanks
Balaji
These funds won’t be suitable for less than 5 year holding because even a limited rise in rates can have NAV impact. Over 5 years plus interest accruals make up for this
Thanks Aarati, this was insightful. Request: for future articles, please include strategy as well. E.g. as articulated in your response to comments. “Yes you can add a lumpsum and also continue sip as long as rate remains above 7%.”
Good feedback! Will try
Nice article. A similar call was given by you in July last year.
Keeping in view the movement in US 10-year Bond yields (from 0.5% to 4.75% now) and the expectation of it crossing 5% soon, do you feel that the Indian 10-year yield may also rise significantly from here (say, 8% plus)?
The expectation that by inclusion of Indian bonds in global indices might result in a reduction in yields might not hold water as the gap between US and Indian yields is the narrowest in many years. For an active overseas bond investor it makes no sense since the Indian bonds have to be held in INR exposing them to currency depreciation risks. However, passive international funds may flow into Indian bonds by default.
Please comment. Thanks
We have the view 10 year in India may not rise beyond 7.5% or so as the only conduit they which US yields impact Indian bonds is via FPI flows. In last 3-4 months India 10 yr has stayed rangebound despite spike in US yield. This is bcos INR has remained stable with an improving CAD. While US debt, the traditional safe haven, is not looking so attractive due to the govt debt crisis.
Of course this is our current view and can change with very significant events
Hi Aarati,
Nice article.
You have Sell recommendation on Nippon India Nivesh Fund which invests in long dated GILT.
Apricate if you can explain reasons for the Sell recommendation?
The fund is extremely volatile, more so than even long-term gilt funds and is less consistent in performance as well – so if a similar strategy can be played with lower volatility, it would be preferable. You can check the old MF Review Tool for reasonings behind our call for any fund. If you hold the fund, the reasoning will also show up in the Quality section of the new Portfolio Review Pro. – thanks, Bhavana
Thank you.
Well articulated. On an average, the SBI Fund looks better than the ICICI Pru Fund. Between these 10 year Constant Maturity Funds and Direct investment into 10 Year GSecs, would it not be better to invest in the latter, as we will realise the entire yield without incurring any TER ?
The funds allow you to hold beyond 10 years and also time your exit. The 10 yr gsec holding will not allow early or late exit
Thanks Aarti. Am doing monthly SIP in SBI Magnum Constant Maturity Fund. Should I do lumpsum now?
Yes you can add a lumpsum and also continue sip as long as rate remains above 7%.
Thanks, will do.
What about HDFC Corporate Bond funds. Are these also similarly beneficial?
That is a completely different call as corporate bond funds benefit from interest accruals and not duration gains
Hi Aarti, is there not some impact of duration in corporate Bond funds with around 5 years average duration? Understably they are not impacted by the 10 year bond yield… But do you expect the yields on corporate bonds to climb over the next year? RBI has committed to liquidity withdrawal.. Will that have an impact?
There will be am impact. But corp bond funds typically rely more on accruals than duration for returns. Today corp bond spreads are fairly good so spike in gilt yields may not lead to equal spike in corp bonds in our view
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