Gaining the Gilt Edge

Investors are surprised when gilt funds lose money, finds Ravi Samalad. But the difference between the top and bottom performers of gilt funds is huge

A few weeks ago, one of our readers wrote to us about the performance of a gilt fund he had invested in. He had invested Rs6 lakh in a long-term gilt fund at an average NAV (net asset value) of Rs20.39 in 2008. When he wrote to us, its NAV had fallen to Rs19.13—down 6%. The investor was surprised. How can one lose money in a gilt fund, he complained. If you think that the word ‘gilt’ is synonymous with ‘risk-free’ over all periods of time, it is not.

Gilt funds primarily invest in government securities (G-Secs) issued by the Reserve Bank of India. These funds also invest in corporate bonds, zero-coupon bonds and treasury bills, certificates of deposit, commercial paper and usance bills, as well as derivative instruments like exchange-traded interest rate futures and interest rate swaps. As you know, the NAV of any fund fluctuates on a daily basis just like share prices because the underlying asset—whether bonds or shares—fluctuate on a daily basis. The fact is: anything that is interest-bearing will go up and down with the market. The value of bonds of any kind is primarily influenced by the prevailing interest rates. If interest rates go down, the value of bonds goes up. The daily NAV of a gilt fund is calculated by valuing a variety of government bonds, which a fund has invested in, that are traded in the market. As interest rates change, the value of the securities in which the scheme has invested, fluctuates as well. This, in turn, will be reflected in the changing value of the fund and its NAV.

In the example we started with, the investor had entered the fund at a time when bond prices were high. When interest rates rose and bond prices fell, the NAV of the fund declined. There is nothing mysterious about a gilt fund declining 6% over two years. The same fund has posted decent returns of 7% since inception. In short, buying gilts does not save you from short-term risk of loss due to market fluctuations.

As TP Raman, managing director, Sundaram BNP Paribas Asset Management Company, explains: “The market risk of a debt instrument can be eliminated only in a situation where a security is held till its maturity. Since gilt funds are generally open-ended funds where investors are allowed to enter and exit at various points of time, the funds may be forced to honour the redemption commitment even if it involves booking losses. Further, as all securities are marked-to-market on a daily basis, the NAV of the fund at any point of time recognises the current fair/realisable value of all securities in the portfolio. This recognition leads to losses (principal erosion) or profits for different investors depending on their entry and exit, when analysed at short periods.”

When it comes to gilts, the usual route for an investor is mutual funds. Retail investors do not have access to government securities because these are dealt in large lots which only institutional players can afford to buy. But gilt funds can pool money from retail investors and buy government securities, offering an indirect route to retail investors. However, most investors invest in such funds without consulting a financial advisor and cry foul if the NAV falls.

When To Buy Gilts

“The right time to invest in a gilt fund is when interest rates in the economy are near their peak levels, inflation expectations are likely to go down, growth slowdown is seen in the months ahead and overcapacities get built up in the economy. An ideal time-frame should be two to four years, depending on the clues from broader indicators in the economy,” adds Mr Raman. The past one year has been a time of rising inflation and rising interest rates, leading to falling value of gilts and, therefore, the NAV of gilt funds.

The principal amount that you have invested may erode due to interest rate fluctuations and mark-to-market formula of securities valuation. Although there is no fixed timing for investing in gilt funds, financial advisors believe that one should ideally invest when interest rates are around 8%. Long-term securities react more in response to interest-rate changes than short-term securities.

Gilt funds are of two kinds—short term and long term. “There is no ideal time horizon for gilt funds; it is advisable to invest when interest rates are high but it is very difficult for a common investor to predict interest rates. The best way for an investor is to go for a short-term gilt fund, where the effect of interest rate changes will be nil, so the NAV will not give you nasty shocks,” says Bhavesh Gajiwala, a Surat-based independent financial advisor (IFA).

Of the 29 gilt funds available, 14 have recorded hugely varying compounded annual returns over five years. ICICI Prudential, JM G-Sec Regular Plan and Templeton India GSF have reported the highest returns of 9%. HSBC Gilt Fund and Taurus Gilt Fund have reported the worst performance of 2% and 1%, respectively, for the same period.

So, here again, you will have to time your buying and selling to avoid losing money in a supposedly loss-free product like gilt funds.

No Sheen on Gilt Funds?

Distributors don’t promote gilt funds aggressively due to the meagre commissions offered (usually 0.15% to 0.40%) compared to equity funds and unit-linked insurance plans (ULIPs) which give 30% of the premium plus trail commission of around 5%. Debt funds don’t offer such upfront brokerage. Gilt funds have remained low-profile because fund houses never promote them as aggressively as equity funds. According to data available with the Association of Mutual Funds in India, total assets under management (AUM) of gilt funds were just Rs3,171 crore, constituting 1% of all categories of mutual fund schemes, compared to equity funds which constituted 22% at Rs168,672 crore as of February 2010.

The performance of the scheme depends on a variety of factors affecting capital markets, such as interest rates, currency rates, foreign investment, government policy, etc.

“Volatility in gilt funds is far lower than that in equity. This, perhaps, makes it less glamorous and attractive. Retail participation in government securities has been a non-starter in India—both directly and through the mutual funds route. There are incentives aplenty for equity funds—right from tax-free dividends, low short-term gains and zero long-term gains. Similar incentives to gilt funds will go a long way in achieving the twin purpose of retail participation in government securities through mutual funds and bridging the demand-supply mismatch in government borrowings which the government is keen to address,” says Mr Raman of Sundaram BNP Paribas.

Source: http://www.moneylife.in/article/5294.html