Medium-term gilt funds may not sustain high returns

Priya Nair

Though the year ending June 30, 2001 proved to be a watershed for equity funds, it has been a period of windfall gains for debt funds. While the medium-term debt funds yielded an average 13.30 per cent, returns from medium-term gilt funds were higher by 390 basis points at an average of 17.21 per cent.

Probably, these returns remind one the days of high gains provided by the scam ridden non banking finance companies (NBFCs). However, a comparison between these two is not fair as gilt funds invest only in government-backed sovereign instruments and hence are free of default risk. Nevertheless, investors should remember that that the current spell of bountiful returns cannot be sustained.

Investors may not continue to realise such whopping returns as the gains are driven by unprecedented rate cuts. Further, the steady fall in interest rates will only pull down the long-term returns since funds invest at lower yields.

Thus, it is important that investors do not approach gilt funds with high expectations. Secondly, given the high volatility in gilts, investors must stay invested for at least two years to earn reasonable returns.

Unlike bond funds, which invest a limited sum in government securities (G-secs), gilt funds are dedicated vehicles for investments in these instruments. Gilts are interest-bearing instruments issued by the government as a part of its borrowing programme.

The government securities market has always been out of bound for the retail investor as the minimum investment is too high. However, entry of mutual funds in this segement has facilitated retail investment, as low as Rs 5,000. But since they were always kept away from gilts, there is little awareness among general investors on gilt funds. Besides gilt funds, PNB Gilts, a subsidiary of Punjab National Bank, and the only listed primary dealer also retails select sovereign bonds with a minimum investment of Rs 25,000.

Debt instruments are susceptible to three important risks - credit risk, liquidity risk and interest rate risk. Since sovereign bonds carry zero default risk, they are also highly liquid and can be traded with ease without any impact cost. However, the high liquidity exposes them to interest rate gyerations , i.e. their prices fluctuate sharply due to higher sensitivity towards interest rate movements.

On the other hand, bond funds are largely invested in corporate bonds, which vary on credit quality and hence, liquidity. This makes them less responsive to interest rate gyrations. Gilt funds have an edge over bond funds on two counts. Firstly, they have potential for greater price appreciation during rate cuts and second, gilts are available for longer maturities vis-à-vis a corporate bond that typically has a life of 3-5 years.

Thus, a fund with investments in longer-dated instruments would yield higher returns than a fund investing at the medium end of the yield curve.

On the contrary, a fund with long-term investments also has higher volatility. During the interest rate hike in July 2000, while the medium-term debt funds gained an average 0.80 per cent for three month, the medium-term gilt funds suffered an average loss of 0.95 per cent. Thus, it is up to you whether you can face the volatility on account of interest rate risks.

Some of the better performing gilt funds include K Gilt Investment, the first fund dedicated to investment in gilts. It has posted a return of 15.19 per cent since launch and 18.88 per cent in the past one-year. The fund, while actively switching across maturities, has so far limited the maturity profile of its portfolio to 9 years to reduce this interest rate risk. With this, the fund has emerged an above average performer.

Templeton India Government Securities Fund (TIGSF) has reaped windfall gains aided by its nimble-footed management. With a one-year return of 20.96 per cent and 18.40 per cent returns since launch, the TIGSF has aggressively leveraged the falling interest rates in its favour. It has also actively handled interest rate risk by realigning the portfolio maturity in line with interest rate outlook.
From a conservative portfolio maturity of 2.51 years in July ’00 when interest rates were hiked, it has today stretched it to 11.08 years to capture the gains of the current rally. Yet, the fund has been fairly volatile.

DSPML GSF seeks to invest in g-secs with maturity of up to 20 years. The fund is a very aggressively managed. With the interest rate cut in early 2000, the fund stretched the portfolio maturity to 11.23 years, but quickly pruned it to 2.53 years in July when the bank rate was hiked. Currently, the portfolio maturity is again at 7.6 years.

With concentrated holdings in select maturities, the fund has emerged as an aggressive gilt fund with its small size aiding this strategy. With a return of 18.26 per cent since launch and a one-year gain of 21.5 per cent, the fund has done better than its category average.

-- Value Research