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A Fund which Doubles Up as a Zero Coupon Bond

There is no direct way for Indian investors to simply buy and hold gilts. Here's a fund which attempts to enable that with superior tax efficiency than gilts

Sometimes, the simplest investments are also the best. For a few months now, gilts in India have offered investors an attractive buying opportunity. Gilts are government-guaranteed and carry no credit risk. With their yields hovering at 8.5 to 9 per cent, they also offer the opportunity to lock into high interest rates and profit from any future gain in prices, if interest rates fall. With inflation coming off quite sharply in recent times and global risks settling down, most people think this is the top of the rate cycle and expect the RBI to start cutting interest rates next year.

But the problem for Indian investors is, there is no direct way to simply buy and hold gilts.

Mutual fund houses run gilt funds which actively trade on gilts of differing maturities. But these carry an interest rate risk as the fund may lose money as it switches in and out of gilts. Fixed maturity plans offer one way out, but if held for less than 3 years, their returns are taxable at one's income tax slab rates. Tax-free bonds from corporates are another option, but there's no supply of them now and the interest on them is paid out every year. So you don't gain from compounding.

As fund houses grapple with different solutions to this problem, there's an interesting one from Tata Mutual Fund. The fund house has repositioned its Gilt Mid Term Fund to deliver the gains of buying and holding long-term gilts to investors. The fund's investment strategy goes thus.

It divides its portfolio into equal halves, investing one half in the gilt maturing in 2022 (8 years hence) and another half in the one maturing in 2027 (13 years hence). The fund house has hit upon this strategy instead of directly buying 10-year paper, because it is more cost effective for investors. “You typically end up losing 20-30 basis points on the liquidity premium on ten-year paper and that impacts returns”, explains Akhil Mittal, a debt fund manager with Tata Mutual Fund.

This strategy allows the fund to lock into the current high interest rates of 8.5-8.6 per cent on these gilts. The fund will thus earn regular income on these gilts and keep re-investing them in the fund, so that your returns can compound over the next 6-7 years. (Tax-free bonds don't allow you to do this). The fund plans to buy and hold these gilts until they mature. If interest rates spike over the next one year, yes the NAV may fall, but investors in the fund can avoid rate risk by holding on for the long term say 6 years or so. As the fund itself plans only on a buy and hold strategy, it will not suffer capital losses from such a spike in rates.

Though the fund is open ended and may face inflows or inflows, the two g-secs are liquid enough to provide both buying and selling opportunities, says Mittal.

However, interest accruals are just one part of the story. If interest rates decline from their present highs over the next three years or so, as most people expect them to, the fund will make gains from rising gilt prices adding to the returns. The fund comes at a modest expense ratio, charging only 0.35 per cent of the NAV for Direct investors and 1.1 per cent for those who buy through a distributor.

Overall, the fund house expects that, if this fund is held for over 6 years, investors can reap benefits of both the high yields and capital gains, if there are any. Because of regularly re-invested interest, you get the benefits of a 6.5 year zero coupon bond (a bond which offers you a discount on purchase instead of regular interest payouts).

So whom will the fund suit?

  • Investors who have a financial goal coming up in 6 years-plus
  • Investors retiring in 6 years' time. They can even set up a systematic withdrawal plan to derive regular 'income' from the fund at maturity
  • Investors who want a long-term, low maintenance debt option, without credit risk and low rate risk