When the Reserve Bank of India (RBI) announces its monetary policy review on December 16, investors of debt fund will look at cues on interest rates. In its last policy review, the central bank indicated a pause, sending positive sentiments to gilt funds. Assets under management of fund houses have started picking up in gilt as risk-averse equity investors are moving to government securities and other debt products.
Gilt funds of mutual funds invest in government bonds (G-secs), which rise when interest rates fall and fall when the rates rise. For investors in gilt funds, the credit risk is almost negligible as the government has zero risk of defaulting. But the catch is the interest rate risk, which can move up and down as the market price of debt security varies with fluctuating interest rates. In fact, analysts say G-secs with higher maturity are more sensitive to interest rates and investors have to look for the tenure in which the fund house is investing their money.
Investors have to keep in mind that gilt funds are not as liquid as other debt funds as G-secs are not actively traded. Moreover, if there is a sudden redemption pressure, fund houses will have no other means but resort to a distress sale. Also, investors must avoid those gilt funds that have a small corpus because these funds are not able to perform well in case of sudden volatility in interest rates and if there is a sudden redemption pressure.
Analysts expect the interest rate to hold steady for a while and start trending down as inflation starts moderating by early next year. The RBI has projected that headline inflation will start cooling by December and likely come down to 7% by March. The economy grew 6.9% in the quarter through September, its weakest pace in more than two years, and the index of industrial production contracted 5.1% in October from a year earlier on the back of a sharp decline in manufacturing output, which constitutes about 76% of the index.
Hiren Dhakan, associate fund manager at Bonanza Portfolio, says primary articles inflation has been a major contributor to overall inflation numbers driven by rapid income growth and changes in food consumption habits and higher minimum support prices. In fact, primary articles inflation touched approximately 23% in December 2010, and averaged 13.5% between January and October 2011. ?However, since late October, primary inflation has been steadily falling and at the same time our GDP growth has been slowing significantly. We are seeing a gradual slowdown in the economy from 9.4% in the March 2010 quarter to just 6.9% in the September 2011 quarter. In such a scenario, we firmly believe that the RBI may resort to rate cuts to boost the slowing economy. As bonds have an inverse relation with interest rates, gilt funds are best placed to benefit from any such RBI action. Gilt funds are also highly liquid and are higher in beta vis-?-vis other bond funds,? he says.
Ashish Kapur, CEO of Investshoppe.com, a wealth management company, says gilt funds suit conservative investors with a long-term perspective. ?Gilt funds become a good investment option when inflation is near its peak and the RBi is not likely to raise interest rates in the immediate future. So it is a good time to consider investing in gilt funds now with a horizon of staying in the fund for at least two years,? he says.
The growing importance of gilt funds can be seen from the fact that the ministry of labour has now included gilt mutual funds in the asset allocation class for exempted provident funds. It, therefore, provides provident fund trustees an opportunity to construct an interest rate hedge in their portfolios. Moreover, to widen the depth, the RBI provides liquidity support and access to the call money market to dedicated gilt funds, which encourages gilt funds to create a wider investor base for the government securities market.
In terms of performance of gilt funds for the near to medium term, data from HDFC Securities show the category gave a return of 4.75% in one year. However, this is lower than the 7.39% that liquid funds gave during the period and much higher than the negative 14.93% from equity funds.
In fact, analysts suggests that retail investors must look at gilt funds with a trading perspective of more than two years and their inverse correlation to stocks could contribute significantly to the yield enhancement of an investor?s portfolio.
Brijesh Damodaran, founder and managing partner of Zeus WealthWays, says gilt in the last few days has been volatile as it was around 8.75% a week ago and is currently at 8.53%. ?So, for an aggressive investor, gilt could be recommended and it can give an annualised double-digit return, provided the interest rates do not go up and are reduced over the next few weeks and months. High risk and return can be expected,? he says, adding that in the last one month, the annualised returns in gilt funds are in double digits and it has run up very fast. However, with extreme volatility around, he cautions only risk takers should go for this fund and the not-so-brave should opt for short-term funds and income funds.