Gilt funds reported the highest returns among debt mutual funds (MFs) in the quarter ended December 2014 on expectations of a softening in interest rates due to falling inflation and an improvement in macroeconomic fundamentals. Between July and December 2014, assets under gilt funds rose about 60% to Rs 9,025 crore compared with a 23% decline in the previous six months.
In a surprise move, the Reserve Bank of India (RBI) on January 15 cut its benchmark repo rate (at which it lends to banks) by 25 basis points (bps) to 7.75%, citing easing pressure on prices, weak demand and lower inflationary expectations of households. The central bank also promised there was more to follow as it signalled a shift to an accommodative monetary policy stance.
Bond yields and prices move in opposite directions and debt MFs are expecting at least another 25-bps cut in rates in the next few months. A fall in rates benefits long-term debt-oriented funds. While a rise in interest rates pushes up yields, a fall in rates brings them down. Any drop in yield will result in capital gains for investors.
Analysts say gilt funds of schemes that invest predominantly in government bonds (G-secs) are a better bet. Gilt funds invest in 10-year benchmark government bonds and 91-day and 180-day treasury bills. While debt funds invest in corporate and government debt paper, gilt funds invest in government securities, which tend to rise when interest rates fall and vice versa. The maturities of G-secs vary as the government issues paper of various tenure and can be short-, medium- or long-term. The credit risk is next to nil as the government has almost-zero risk of defaulting, but the interest rate risk rises as the market price of debt securities varies with fluctuating interest rates.
Experts say gilt funds are an important part of asset allocation, thanks to their inverse correlation to stocks, and they could contribute significantly to a portfolio’s yield enhancement. Going ahead, debt funds investing in government securities, as well as other duration funds with smaller exposure to government funds such as income or bond funds or short-term and ultra short-term funds, are expected to do well. Fund houses are promoting gilt funds by emphasising risk-free returns, but they cannot give assured returns because of interest rate risks.
Analysts say G-secs with longer maturities are more sensitive to interest rates and investors have to look at the tenure for 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 sudden redemption pressure, fund houses will have no choice but to go for distress sale. Analysts also advise that investors must avoid gilt funds with a small corpus as they will not be able to perform well in case of sudden volatility in interest rates.
In fact, Crisil-Amfi Gilt Fund Performance Index delivered an absolute return of 7.7% for the quarter ended December. Data show that over the last one year, yields on the benchmark 10-year government security have fallen nearly 100 bps from 8.82% to 7.85%. But a chunk of the fall — 66 bps — happened in the last three months. Also, the average maturity of gilt-category holdings in the one-year period rose from 12.09 years to 16.96 years.
Across debt categories, funds with longer maturities fared better than peers. For instance, the Crisil-Amfi Gilt Fund Performance Index and the Crisil-Amfi Income Fund Performance Index delivered 16.40% and 13.79%, respectively, compared with Crisil-Amfi Short Term Debt Fund Performance Index’s 10.82% and Crisil-Amfi Ultra Short Fund Performance Index’s 9.14%.
Analysts say 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. To give a push to gilt funds, the ministry of labour has included gilt MFs in the permitted asset allocation for exempt provident funds (PFs). It also provides PF trustees with an opportunity to construct an interest rate hedge in their portfolios.