How to Invest in Gilt Funds?
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Rama Krishna Vadlamudi, HYDERABAD
18 August 2012
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SUMMARY:
Different
asset classes give different size of returns depending on the time periods. In
the Indian context, common stocks provided fabulous returns between 2003 and
2007. Gold and other commodities have been giving hefty returns since 2003.
Stocks of consumption-oriented and pharmaceutical companies have been doing
well since 2008 and real estate too has given sturdy returns in the last
decade.
Now
the time has come for Indian investors to forecast that interest rates will
fall even though predicting interest rate movements is difficult. The
probability of interest rates going down is very high considering the slide in
GDP figures.
Despite
the entrenched inflationary pressures, rising fiscal deficit, deficient
South-West monsoon and global headwinds, the Reserve Bank of India in all
probability is likely to reduce its benchmark interest rates in the next few
months. India’s
new finance minister, Mr P.Chidambaram, seems to be veering round to the view
of lower interest rates stimulating GDP growth.
All
these developments point to a softer interest rate regime, which will trigger a
rise in bond prices. If investors are of the same opinion, they can consider
investment in gilt mutual funds that invest predominantly in government
securities of longer maturity.
Two
gilt funds I have zeroed in, after extensive research, are:
1. Birla
Sun Life Government Securities Fund Long-Term, and
2.
Kotak Gilt Investment Regular.
These
funds are of low-risk category and they invest mainly in government securities.
Due to their exposure to government bonds, they bear no default risk but they
carry interest rate risk, the risk that bond prices may fall when interest
rates rise. Please read on the full article…
What are Gilt Funds?
Gilt funds are debt mutual funds
that invest mostly in Government securities and a small portion in short-term
money market instruments. Government securities (hereinafter referred to as
G-Secs) are bonds issued by the Central Government and State Governments – they
carry sovereign guarantee. Basically, government securities are promissory
notes issued by a government for raising money. Because they are guaranteed by
the government, they are known as gilt-edged securities or simply gilts. The
major investors in G-Secs are banks, insurance companies, RBI and primary
dealers.
Gilt funds keep a small portion
of their funds in money market instruments (that offer higher liquidity), such
as, commercial papers, certificates of deposit, call money, CBLO, or treasury
bills. Keeping certain amount in money market papers enables the gilt funds to
meet investor redemptions, make profitable investments in attractive papers and
take bets on G-Secs depending on the market conditions.
What are the Best Gilt Funds?
Indian
investors have a wide variety of debt mutual fund options. Gilt funds are a
type of debt mutual funds. My research on the gilt funds available in India shows
that investors can consider the following gilt funds for investment depending
on their investment needs, risk appetite, time period and availability of
surplus funds:
1. Birla Sun Life Government Securities Fund
Long-Term:
Present NAV is Rs 31.99 (growth
option)
Latest AUM is Rs 306 crore
2. Kotak Gilt Investment Regular:
Present NAV is Rs 37.96 (growth
option)
Latest AUM is Rs 152 crore
You may
see Appendix I for full details of the above schemes and other gilt funds. The gilt funds given in the Appendix I
typically invest in long-term bonds. Prices of long-term bonds are more
sensitive to interest rate changes than prices of short-term papers. As such,
long-term bonds gain the most when interest rates fall. On the contrary, if
interest rates rise, the prices of long-term bonds lose more compared to
short-term bonds.
If you want to read
more about government bonds, just click:
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It is
not advisable to invest in gilt funds that have very low AUMs. Some gilt funds
are having meager AUMs of Rs 10 crore or even Rs 1 crore .
What are the Risks
involved?
If I say government bonds are
risk-free, it is only a half-truth. G-Secs do not carry any default risk, which
means that the chances of losing one’s money in G-Secs are practically zero.
However, their market prices are likely to fall now and then depending on the
interest rates (interest rate risk). Market prices of G-Secs are influenced by
rising or falling inflation, interest rates, growth numbers of GDP/IIP, crude
oil prices, liquidity available with banks, RBI’s open market operations and
government’s market borrowings.
Because gilt funds predominantly
invest in G-Secs, the net asset value (NAV) of a gilt fund is also susceptible
to above mentioned factors. The returns of gilt funds also depend on the fund
managers’ ability to predict the interest rate movements. Safety of principal
in a gilt fund is, more or less, guaranteed if an investor is able to hold the
fund till the maturity of the underlying instruments.
To know more about
bond risks, just click:
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Past Returns of Gilt Funds
The returns provided by gilt
funds between 2000 and 2003 are the best returns in its class so far. For the
first time in the last two decades or so, interest rates started falling in
July 2000 once the BJP-led NDA government decided to cut interest rates by
announcing a substantial reduction in interest rates of PPF, NSC, KVP and other
instruments.
The benchmark 10-year G-Sec yield
fell from a level as high as 11 per cent in 2000 to as low as 5.1 per cent by
the end of 2003. The steep fall in yields resulted in gilt funds making
windfall profits in their G-Sec portfolio. Even banks made substantial profits
in their G-Sec portfolios during that time. It may not be irrelevant to recall
that this low-interest rate regime had triggered massive investment boom by
Indian corporates that had continued till 2007/2008. Thanks to the Vajpayee
government!
After the collapse of Lehman
Brothers, gilt funds once again delivered excellent returns. Interest rates in India had undergone a steep fall
between September and December 2008. During that short period of four months,
many gilt funds delivered spectacular returns of 20 to 35 per cent.
The flip side is that gilt funds
can lose money in the short-term. Many gilt funds lost 5 to 12 per cent of
their value during the January-March 2009 quarter. However, investors can
recoup their money provided they are able to hold their units for another two
to four quarters. (See Appendix II for more information).
Other Features of Gilt
Funds
- Gilt funds provide good liquidity to investors –
investors can redeem their units in two or three working days. To meet
redemption needs of investors, gilt funds keep some money in money market
instruments.
- They do not carry any entry loads, but some may
charge one per cent exit load
- Investors typically invest more money in gilt
funds when interest rates start to fall
- Investors typically withdraw their money from
gilt funds when they perceive that interest rates reached a bottom and when
chances of rates falling further are remote
- Tax
liability: Investors (resident individuals) have to pay short-term or
long-term capital gains as follows:
- Short-term capital gains: If the holding
period of a gilt fund is less than 12 months,
the tax rate is: At the applicable rate to the resident individual
- Long-term capital gains: If the holding
period of a gilt fund is more than 12 months,
the tax rate is: 10.30% of the capital gains with indexation benefits,
or 20.60% without indexation benefits.
Bond Prices and Yields
There is an inverse relationship
between bond prices and yields, that is, if bond prices go up, their yields
will come down. And when bond prices weaken, the bond yields rise. Generally,
if interest rates come down, the NAV of a gilt fund will go up and vice versa.
There is a close link between
movement of inflation and bond yields. In general, if inflation is rising, bond
yields too will increase and bond yields fall when inflation is on the decline.
Outlook for Government
Bonds
Reserve Bank of India reduced statutory liquidity
ratio (SLR) of commercial banks from 24 per cent to 23 per cent with effect
from 11 August 2012. This move by RBI indicates that banks are likely to invest
lesser amount in G-Secs going forward. However, in order to provide liquidity
to banks, RBI has been buying G-Secs for the past several years. According to
RBI data available up to March 2012, the biggest holders of G-Secs are
commercial banks (36%), followed by, insurance companies (21%), RBI (14.5%) and
primary dealers (10%). RBI is the third biggest holder.
It is interesting to note that
RBI has been the biggest buyer of government securities (through its OMO or
open market operations) in the past five years, which has seen the percentage
of G-Secs held by RBI jumping from 6.5 per cent of the total holdings in March
2007 to 14.5 per cent in March 2012. In fact, this is the highest percentage
held by RBI since the data made available from 2007. What would happen if RBI stops buying G-Secs from the markets through
its open market operations? My personal feeling is that this is biggest risk
that will be faced by G-Sec investors in future.
RBI has been under pressure to
reduce interest rates from several quarters, including the industry and finance
ministry. But, RBI’s hands are a bit tied in the face of grim outlook on
inflation front and it has been impressing upon the Central Government to rein
in its ballooning fiscal deficit. Due to the deficient South-West monsoon, the
government will be hard pressed to spend more money on relief measures for the drought-affected
population in rural India.
The good thing is that food grain stocks with the government are more than
enough to alleviate the drought impact.
The government’s inaction on the
policy front continues for long – with no clarity on economic reforms,
pass-through of increased diesel and LPG prices to the consumers and other
measures. Doubts have been expressed about the government’s ability to reduce
fiscal deficit to a manageable level in the face of many adversities.
Some pundits are of the opinion
that RBI may not be able to reduce interest rates in the next one or two months
in the face of entrenched inflationary pressures. However, the new finance
minister, P.Chidambaram seems to be rooting for interest rate cuts.
International rating agencies,
S&P and Fitch have put ‘negative’ outlook on India’s sovereign rating. Threat of
India’s
sovereign debt rating downgrade is imminent – at which rupee may weaken and the
chances of FIIs pulling out their money from G-Secs are more likely. FIIs hold
only a small percentage of G-Secs. However, any big selling from FIIs may
dampen G-Sec prices in future.
Investment Action and Strategy
Overall, my sense is that RBI
will have to reduce interest rates in the next few months. Data on GDP figures for the April-June 2012
quarter will be out on 31 August 2012. The government’s borrowing program for
the half-year beginning October 2012 will be announced by the end of September
2012. Rating action from the rating agencies is also expected in the next two
to three months. All these events are likely to have a big impact on G-Sec
market.
My guesstimate is that RBI will
reduce interest rates going forward. Before such RBI action, investors can
consider investing in two gilt funds, namely, Birla Sun Life Government
Securities Fund Long-term and Kotak Gilt Investment Regular. These are low-risk
funds and may provide good returns to investors depending on their entry point.
However, investors are to be ready for a downside risk in shorter time periods.
Investors can enter the G-Sec
market, when the benchmark 10-year 8.15% G-Sec yield touches 8.5 per cent or
above – buying units of the gilt funds at different levels of the benchmark
10-year G-Sec yield. The current benchmark yield is 8.22 per cent.
Investors have to closely and
actively follow the G-Sec market by keeping a watch on macro economic data,
RBI’s policy actions, reform initiatives (if and when) from the government,
crude oil prices, rating actions by S&P and Fitch, and others. Gilt funds
are not suitable for passive investors. ‘Buy and hold’ strategy will not work
here.
It may not be optimal for
investors to hold the gilt funds for longer periods. They have to exit the gilt
funds if any one of the following events occurs:
1. The investment gives a pre-tax
return of 12% to 18% in a short span of 3 to 6 months.
2. Other assets classes, like,
equities, commodities, etc., have fallen very sharply. If such an event occurs,
investors can switch their funds to such asset classes for better returns.
3. The 10-year G-Sec yield
touches a yield of 7.5% or lower from a peak level of 9%.
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Appendix I - Returns of Select Gilt Mutual Funds
Name of
the Scheme
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AUM
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NAV (Rs)
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Crisil
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Returns %
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Rs crore
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as on
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Rank
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2012*
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2011
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2010
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2009
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2008
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2007
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30-Jun-12
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16-Aug-12
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%
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%
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%
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%
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%
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%
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Birla Sun
Life G-Sec fund Long-term
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306
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31.99
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1
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6.6
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6.9
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9.3
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17.5
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5.6
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4.7
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ICICI Pru
Gilt Investment
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222
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37.18
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2
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6.4
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5.9
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5.2
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(6.7)
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36.5
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8.4
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IDFC G-Sec
Investment Plan-A
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19
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21.11
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2
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7.2
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9.5
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3.4
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(9.3)
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30.9
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6.3
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Kotal Gilt
Investment Regular
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152
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37.96
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1
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9.7
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7.1
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4.9
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(5.0)
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28.3
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4.8
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* from 1.1.12 to 16.812; Data source:
MoneyControl.com; AUM – assets under management
Rank – Ranks
are given by Crisil Limited –Rank 1 is the highest rank.
Appendix II. Best/worst Quarterly Returns of Select Gilt Mutual
Funds
Name of the Scheme
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Best return %
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Best return %
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Worst return %
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Worst
return %
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Q2-2012
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Q4-2008
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Q1-2009
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Q1-2007
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Birla Sun Life G-Sec Fund
Long-term
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3.4
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7.4
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(2.1)
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(1.1)
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ICICI Pru Gilt Investment
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3.6
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31.2
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(10.9)
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(0.7)
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IDFC G-Sec Investment
Plan-A
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4.5
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25.5
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(12.1)
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(0.1)
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Kotal Gilt Investment
Regular
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5.3
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26.1
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(11.0)
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(1.6)
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Date
source: MoneyControl.com
Abbreviations:
CBLO – collateralized borrowing and lending mechanism – a money market
instrument of CCIL; FII – foreign institutional investor; GDP
– gross domestic product or national income; IIP – index of industrial
production measuring country’s industrial activity; NAV – net asset value of
the fund; RBI – Reserve Bank of India; SLR – statutory liquidity ratio, the
minimum that banks have to keep in government securities; Yield - A bond’s
yield is loosely defined as the income one earns on it as a percentage of what
one spent on it. Theoretically, it is calculated by dividing
the amount of interest it will pay during a year by its price.
Disclaimer: The author is an
investment analyst and writer. (He has just completed Level 2 of CFA Program from the US). His views are personal. He has a vested interest
in the stock/bond markets. He may change his views very fast without any notice
depending on the market and economic conditions. His views should not be
construed as investment recommendation. There is a risk of loss in equity/bond
investments. Investors need to consult their certified financial adviser before
making any investment decisions.
