As many of you might be aware, when interest rates fall, bond prices rise and investors of debt funds gain. This is a basic principle on which debt funds work. However, bond funds are not risk free. Primarily they carry two risk; default risk and interest rate risk. It is believed that gilt funds, a category of debt funds, are virtually free from risk of default as they are backed by sovereign guarantee. Savvy investors play them as a proxy on interest rate movement in the economy. In the current scenario where it is almost taken for granted that RBI would continue to cut rates, whether to invest in gilt funds is tricky. Let's first understand what makes the debt markets confident that RBI would almost certainly continue to cut policy rates.

Dipping inflation is believed to be one of the primary reasons why RBI may favour another rate cut.
 

WPI Inflation mellowed down further

Data as on May 14, 2013
(Source: Office of the Economic Advisor, PersonalFN Research)  

As depicted in the graph above, inflation measured by the movement of Wholesale Price Index (WPI) has substantially dropped in last 3 months. This is mainly on account of noticeable ease in manufacturing and food inflation. Manufacturing inflation for April 2013 has been 3.41% (down from 4.07% in March and 5.27% in April 2012) and food inflation too fell to 6.08% in April 2013 (down from 8.73% reported in the previous month and from 10.92% in April 2012).

Weak recovery in manufacturing industries has been the other factor that may trigger a rate cut is. Factory output as measured by the movement of Index of Industrial Production (IIP) shows that the growth has been anemic.

RBI started cutting rates in April 2012 and has not raised them even once thereafter. In Financial Year (FY) 2012-13 RBI reduced rates by 100bps or 1% in a phased manner. In the current financial year too, RBI has reduced policy rate by 25bps or 0.25% to take the quantum of such cuts to 1.25% from the peak of rates recorded in post crisis scenario. As a result, Yield on 10-Year G-Sec benchmark bond has been witnessing a downward trend. Moreover, in the wake of lower interest rates in the developed economies and favourable policy changes targeted at attracting more inflows; Foreign Institutional Investors (FIIs) have pumped in money in Indian debt over last few months pushing yields down.
 

	Returns (Absolute %)
	1 Month	3 Months	6 Months	1 Year
Category Average- Short Term Gilt Funds	0.9	2.9	5.7	9.6
Category Average- Long Term Gilt Funds	2.0	5.2	9.0	13.5
I-Sec Si-BEX	0.9	3.0	5.6	10.0
I-Sec Li-BEX	2.8	6.5	11.0	16.5
I-Sec Composite Gilt Index	1.8	4.9	8.6	13.4

Data as on June 07, 2013
(Source: ACE MF, PersonalFN Research)  

Falling yields have been a boon for gilt funds which have generated attractive returns over last 1 year. However, the performance of short term and long term gilt funds has been mixed over last 1 year. This suggests that although falling interest rates may have made investment in G-Sec attractive; gilt funds as a category has not made its mark. Of course, there have been some outstanding individual performances but they are only few.

Why investors need to be cautious now?

RBI, from time to time has expressed its concerns over widening current account deficit, which in simple words, measures country's indebtedness to the external world. Fiscal deficit has also been alarming. Weakening rupee doesn't bode well either as it may threaten to accelerate the inflation owing to higher imports. In such scenario, there would be limitations on RBI to cut rates to assist growth and rally in G-Sec may seem to be just overdone. Status quo maintained by RBI would be taken as a negative and yields on G-sec (and other debt instruments) may rise.

PersonalFN is of the view that those who want to invest in debt funds for longer time horizon should prefer flexi / dynamic debt funds which not only diversify across instruments (unlike G-Secs) but also across maturities. Speculating on interest rate may prove to be hazardous as it might result in losses or may generate poor returns if your calls on the direction of interest rates go wrong. Any debt fund, including gilt fund, involves risks and you should check your risk appetite before investing.

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