Fenil's Library

With interest rates easing, the returns have started improving

ICRA Online Research Desk

Saying 2008 was a tough year would be an understatement, what with the equity markets crashing like a pack of cards and the world at large being heaped with unending financial woes. Investors at large suffered.

But one class of funds did exceedingly well during the year — gilt funds.

The term ‘gilt’ originated to connote British government certifications that had gilded edges. Going forward, they have come to be defined as mutual funds that predominantly invest in government securities (G-secs). 

These funds are ideal for retail investors as they allow them an opportunity to invest in government papers, which are otherwise dominated by corporate investors.

Gilt funds are possibly the safest class of mutual funds on offer. Indeed, the basic purpose of investing in gilt funds is to generate returns at negligible risk as it is highly unlikely the government will default on the debt raised by it.

G-secs include central government dated securities, state government securities and treasury bills.

Since 2004, the returns from gilt funds had been far from impressive. This was largely because the crescendo of economic boom began building around this time and interest rates were on their way up. Consequently, the return on government bonds began diminishing.

With the stock markets booming — the BSE Sensex rose 65% in 2004 — there were more lucrative, albeit more risky, assets to which investors flocked.

See table for the gyrations in annual returns delivered by gilt funds.

Till 2003, double-digit returns on gilt funds were the norm. However, at the end of 2004, the average longer term gilt fund actually delivered a loss to its investor. 

These funds can also be quite volatile in terms of returns delivered. The 10-year dated G-sec yield touched a level of as high as 9.46% and dropped to as much as 5.25% over 2008, which gives an indication of volatility in the market.

It is no surprise then that gilt funds suffered a tremendous outflow of assets for around four years since 2004.

At the beginning of 2004, the assets under management of gilt funds stood at Rs 6,062 crore, which was down to a mere Rs 2,849 crore by January 2008. Year on year, the returns on gilt funds between 2004 and 2007 were also quite dismal.

However, things have changed considerably over the past year. Today, the assets managed by gilt funds are at an all-time high of Rs 10,661 crore and we are witnessing double-digit returns again. 

As of December 31, 2008, the average long-term gilt fund delivered anywhere between 18% and 45% over a one-year time frame.

And in just the last three months of 2008, the average long-term gilt fund returned as much as 20%.

This is because the Reserve Bank of India (RBI), which over the past four-and-a-half years was relentlessly raising interest rates to curb liquidity in the economy, has done an about turn and started slashing rates.

The higher trading volume in the G-secs market has made gilt funds a preferred investment destination. Further, in the last two months there has been strong investor interest in debt funds as a whole due to expectations of interest rates falling further. 

All the same, investors need to keep in mind that investment in gilt funds isn’t all safe. While it is true that risk of default in G-secs, issued as they are by the government, there is always the risk of interest rates changing.

When interest rates move up, bond prices move down and vice versa.

Bond prices could fall because of other factors as well. For instance, while investors have been optimistic about G-secs and the market has been gung-ho about declining interest rates, gilt funds delivered negative returns during the month of January 2009. The average long-term gilt fund lost 6.27% over the month.

Thus, apart from being volatile over the short term, these funds can deliver losses as well.

As a lay investor, you could keep a lookout for certain key indicators in newspapers to follow the trends in gilt funds. The cash reserve ratio (CRR) and repurchase rate (repo) are good indicators as an increase in either would bring bond prices down and vice versa.

Bond prices are also sensitive to inflation as the central bank is likely to increase the CRR and repo lest inflation spiral out of control. Higher inflation is viewed as a negative and can pull bond prices lower.

An increase in government borrowing can also queer the pitch for bonds as traders just hate it. Of late, an increase in government borrowings has been a big dampener to investor confidence.

Call rates, which are an indicator of short-term liquidity in the market, influence bond prices indirectly, for if call rates are increasing, traders and banks are likely to sell G-secs held by them, triggering a drop in prices.

Also, instead of bond prices, you will find references to the ‘yield’ of a particular instrument. When bond prices fall, the yields increase and vice versa.

Selecting a fund that fits in with your risk profile is extremely important. A nervous investor, uncomfortable with negative returns even over the very short term, will invest in a very different sort of gilt fund compared with a more risk-tolerant investor.

Next week we will talk about the differences between short-term and long-term gilt funds, and the applicable entry loads as well as expense ratios these funds charge.