Fenil's Library

Vivek Kaul. Mumbai

Mutual fund investors too move in hoards.

The flavour this season is of gilt funds, or mutual fund schemes that invest in debt securities issued by the government. Some mutual funds have been selling these schemes on the plank, "invest in the safety of government securities (G-secs)." 

However, gilt funds that invest in G-secs aren't quite the same as the G-secs themselves. Let us try and understand why.

The Government of India, like almost all governments around the world, spends more than what it earns. In order to bridge the deficit, it issues debt securities, which pay a certain coupon (interest) at fixed intervals. 

These securities are similar to bank fixed deposits which have a fixed tenure of investment and pay interest at regular intervals. People invest in these securities primarily because they are deemed to be the safest mode of investment. Worse come to worst, the government can always print money and return the invested amount. 

Still, this doesn't quite mean that someone investing in such a security will never lose money. The only kind of investor who can be sure of never losing money on a G-sec is one who invests in a security and holds it till maturity. 

Take an investor who buys a G-sec, which has a tenure of 10 years (i.e., it matures in 10 years) and pays an interest of 8% a year. If the investor holds on to this investment till the time it matures, he gets an interest of Rs 8 for every Rs 100 invested, every year, for the 10 years. At the end of 10 years, he also gets back the amount invested. 

But, what if the investor wants to sell out after five years? The security he had invested in at that point of time has five more years left for maturity. 

Let us further assume that at that point of time, the government issues a five-year G-sec that pays a 12% rate of interest. 

Now, there are two similar securities in the market, each with a remaining tenure of five years. But the rates of interest are different. What will happen? Investors will sell the security that pays a lower rate of interest and invest in one that pays a higher rate of interest, given that the risk of investing is the same, since both securities are issued by the government. 

When this happens, the price of the security, which pays the lower rate of interest will fall, leading to losses for investors who had invested in the security.

This brings us to the basic premise of investing in G-secs: When interest rates go up, the prices of G-secs fall and when interest rates go down, prices of G-secs go up.

In fact, the debt market does not wait for the interest rates to rise or fall, to make a decision. If the market expects interest rates to go up, prices of G-secs fall and vice versa. 

This is something everybody investing in gilt funds should bear in mind. As explained above, gilt funds are mutual fund schemes that invest in G-secs.

Now, when interest rates are expected to go up, the prices of the G-secs that a gilt fund has invested in go down. Given this, the net asset value of a single unit of the gilt fund also goes down, so the investor has a chance of making a loss on his original investment. Also, the longer the maturity of the G-secs a gilt fund has invested in, the greater is the fall in price, and hence, greater the losses for the investor.

This is where the capabilities of a fund manager come into play. Wheninterest rates are expected to go up, fund managers should be movingtheir investment into G-secs thatmature in lesser periods of time and dumping those that have longer maturities, so that if prices do fall, the losses are lesser.

In a reverse situation, when interest rates are expected to go down, fund managers should be moving into securities with greater maturities, so that if the prices rise, the investors' profit is more. 

But as most equity mutual fund investors found out towards the beginning of 2008, most fund managers cannot predict when the tide turns. Similarly, right now everybody expects interest rates to continue falling and hence gilt funds to perform well. But it must be kept in mind that interest rates cannot continue falling forever. And no one really knows when the tide will turn.

The same logic applies more or less for income funds as well. Income funds invest in medium- and long-term debt securities issued by corporates. 

As always, investors should not bet their lives on one mode of investment. 

k_vivek@dnaindia.net