Gilt Edge

The 25 basis points increase in the policy rate by the Reserve Bank of India on June 16, which was the 10th hike since March last year, has sent a signal that the interest rate cycle has more or less peaked and is expected to taper off as headline inflation starts trending down. Investors who have taken the debt route will have to look for instruments that yield more than bank or corporate fixed deposits.

Analysts say that with equity markets showing range-bound movement, gilt funds of mutual funds that predominantly invest in government bonds (G-secs) can be a better bet. While debt funds invest in various corporate and government debt paper, gilt funds invest in government securities, which tend to rise when interest rates fall and vice-versa. G-secs’ maturity varies as the government issues paper of various tenor and can be short, medium and long term. 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.

Sanjiv Mehta, founder of financedoctor.in, a wealth management firm, and author of Winning the Wealth Game says a long-term gilt fund is useful for capital gains in a declining interest rate environment. “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,” he says.

During the global financial crisis, when the central bank reduced the policy rate by 275 basis points between December 8, 2008, and April 21, 2009, to infuse liquidity in the banking system, prices of long-term bonds and G-secs appreciated and funds that were invested in such securities benefited. Funds houses also promote gilt funds by emphasising their risk-free returns, but they cannot give any assured returns because of the interest rate risks.

Analysts say G-secs with higher maturity are more sensitive to interest rates and investors have to look for the tenor 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.

Performance of both medium- and long-term gilt funds shows that on an annualised basis, they gave a return of around 4.5% last year and 7% in the last three years. This indicates that the funds have been be able to give similar returns that other fixed-income instruments like bank deposits yielded. “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,” says Sanjiv Mehta of financedoctor.com.

Ashish Kapur, chief executive officer of Investshoppe.com, a Delhi-based wealth management company, says gilt funds suit conservative investors with a long-term perspective. “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 are likely to peak out in the near future, 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,” he says.

Investors also have to consider certain global economic factors that could suddenly spike the interest rate in the domestic market. For example, any further quantitative easing in the US can increase the price of oil and other industrial commodities. This will push up inflation even in India as we import a large quantity of crude.

Interestingly, the ministry of labour has included gilt mutual funds in the permitted asset allocation for exempted provident funds and it provides provident fund trustees an opportunity to construct an interest rate hedge in their portfolios. The central bank also provides liquidity support and other facilities such as access to the call money market to dedicated gilt funds. These facilities encourage gilt funds to create a wider investor base for government securities market.

Analysts say the central bank’s next monetary policy will give a clear direction on the movement of gilt funds and economic data like index of industrial production, core sector data, export numbers and credit growth trend will determine the movement of interest rate. However, analysts say the interest rate cycle has more or less peaked and being invested in gilt funds will be a wise call.

Source: http://www.indianexpress.com/news/gilt-edge/806338/0