In the quarter ended June, gilt funds gave superior returns, outperforming both equity and debt-oriented funds on the back of softening of yields as the Reserve Bank of India (RBI) reduced the repo rate by 50 basis points in its annual Monetary Policy for 2012-13 in April 2012. Bond yields and prices move in opposite directions ? which means when yields fall, prices or net asset values of bond funds rise and vice versa.

A report by Crisil says gilt funds returned 3.1% in the quarter and were the best performers across the 22 mutual fund categories that were ranked by the rating agency.

Equity funds gave returns of 1.39% during the quarter compared with 1.93% by the S&P CNX Nifty. But the high returns of gilt funds did not translate into higher asset under management for the category. For the three months to June, it fell 13% to R25.74 billion compared to R29.68 billion in the previous quarter as investors were uncertain about the pace at which RBI would reduce interest rates.

Why gilt funds

Analysts say that with equity markets showing range-bound movement, gilt funds that invest in government bonds (G-secs) could be a good investment. The credit risk is next to nil as the government has zero risk of defaulting, but the interest rate risk rises as the market price of debt security varies with fluctuating interest rates. Gilt funds are a very important part of asset allocation with their inverse correlation to stocks and they could contribute significantly to the yield enhancement of a portfolio.

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. Gilt funds are not as liquid as other funds as G-secs are not actively traded, and if there is a sudden redemption pressure, fund houses will have no other means but resort to distress sale. Analysts also say that investors must avoid those gilt funds that have a small corpus, as they will not be able to perform well in case of sudden volatility in interest rates.

Downside risks

Analysts say gilt funds become a good investment option when inflation is near its peak and the Reserve Bank of India is not likely to raise interest rates in the immediate future. Since interest rates have peaked, it is a good time to consider investing in gilt funds now with a horizon of staying in the find of at least two years.

Before investing in gilt funds, investors must also look at certain global economic factors that could suddenly spike the interest rate in the domestic market. For example, the drought-like situation in the US and India could spike commodity prices like wheat, pulses and edible oil which could push up the the consumer price index. Also, since the global oil prices are once again inching over $100 a barrel, it could push up the government’s oil import bill and stroke inflation in the domestic economy.