Is this the right time to invest in Gilt Funds?
Feb 07, 2013

Author: PersonalFN Content & Research Team

RBI has provided much needed relief to borrowers by lowering the policy rate by 0.25% in its 3rd quarter monetary policy on January 29, 2013. The strident demands for a rate cut were making rounds ever since growth started cooling off. However, concerned about sticky inflation, RBI refrained from lowering rates aggressively. It has so far cut 0.75% rates in the current fiscal. Besides benefiting borrowers, the accommodative monetary policy gives debt market investors a reason to smile. Yields and interest rates move simultaneously in the same direction while bonds prices share an inverse relationship with interest rates. As the market was hoping RBI to cut rates going into 3rd quarter monetary policy; there was a robust buying interest witnessed in debt instruments.

Recent Scenario

Debt / fixed income mutual funds have made smart gains over last 2 months. Usually in a diminishing interest rate scenario, the debt instruments with longer maturities, which are highly sensitive to interest rate movement, rally more than instruments with short maturity profile. Moreover, sovereign debt i.e. debt instruments issued by central and state governments have the highest bearing of interest movement as against other debt instruments of comparable maturity profile. This is mainly because of their near risk free nature. Debt securities issued by Central and State government is considered risk free as it is backed by sovereign guarantee. G-sec debt forms the basis of bond pricing in other markets such as corporate debt market. When yields in G-sec market start tapering off, the borrowing cost of government (in other words that of a nation) comes down. Over last 2 months yield on 10 year 8.15%, 2022, benchmark bond has fallen by about 40bps or 0.4% triggering rally in bond prices. Gilt funds (dedicated funds which invest in G-sec debt) witnessed appreciation in their net asset value as the government bond prices appreciated. Now that interest rate cycle has already peaked and rates are coming down investors are lured to invest in gilt funds. This is evident by the corpus mopped up by gilt funds over last 3 months. The Assets under Management (AUM) in these schemes has nearly doubled from September 2012 to December 2012. But to know if there is more steam left in G-secs and whether one should invest in gilt funds now, we must assess macro-economic factors that would impact the movement of yields on G-sec securities going forward.

Factors to watch out for

The state of government finances, Inflation outlook, interest rate structure, growth outlook and liquidity in the system are some important factors that would decide the attractiveness of G-sec debt to investors. One must understand that many of these factors are interrelated. The government usually borrows to bridge the gap between its revenue and expenditure. Unless the growth outlook is robust it becomes difficult for governments to manage its fiscal health as it is difficult to grow the revenue and cut expenditure. The weakness in INR is an additional burden that has increased the import bill and there by the price of many goods and services. For a country like India which heavily depends on imports to meet its energy requirements; inflation is even more difficult to manage than it would otherwise be. Inflation affects the interest rate movement and the credit flow which in turn impacts growth. Moreover, liquidity is affected by credit flow and demand for credit in the system.

However over last 6 months, Inflation has moderated considerably and is expected to hover around current levels for most of the time in financial year 2013-14. Inflation in manufacturing products which is the largest component of WPI has lowered considerably over past few months. However, inflation in primary articles still remains worrisome.

Will Inflation Ease Further?
WPI Inflation

(Source: Office of the Economic Advisor, PersonalFN Research)

On the other hand, manufacturing growth measured by Index of Industrial Production (IIP) as well as growth in Gross Domestic Product (GDP) has been low and outlook too is gloomy. The RBI has already cut the GDP estimate to 5.5% from 5.7% for FY 2012-13. IIP growth has decelerated sharply in the current fiscal and has slipped into negative in 5 out of first 8 months of FY 2012-13 ending on November 30, 2012. This has increasingly made the task of RBI difficult to strike a balance between growth and inflation. Cooling growth and range bound inflation leaves some room for RBI to go for rate cuts in FY 2013-14 say to the tune of 75 bps or 0.75% which would be a positive for G-secs.

But here's a word of caution. State of government finances is not very encouraging and government faces a tremendous pressure to rein in fiscal deficit which poses an immediate threat to rally in bond markets. The finance ministry is trying to get financial health of the state back on track which was lying in complete disarray till recently. Current Account Deficit (CAD) shot up to 5.4% as a percentage of GDP in Q2 FY 2012-13. The CAD is experienced when country's import bill is higher than its export revenue. The high CAD coupled with low investment activity doesn't only reflect low savings and high inflation but is also a significative of weaker currency. Mounting Deficits require government to rationalise its spending and boost revenue. Against this backdrop, Budget 2013 would be crucial for debt markets and especially for G-secs.

In a bid to curtail fiscal deficit, government has been working on rationalising its expenditure. As a part of it, it's been decided to completely eliminate losses on diesel, which is subsidised at present. Diesel prices will creep up by 40-50 paise every month till losses are fully eliminated. Government is also expected to announce reduction in subsidy on non-urea fertilisers by 20%-25% by April 2013 but is expected to be implemented with retrospective effect from February 1, 2013. With repeated failures in observing fiscal prudence India has lost credibility on international level and rating agencies have persistently raised their concerns and have even threatened to assign junk rating to Indian sovereign debt. If this happens it will not only raise borrowing cost on new funds but would also lead to currency depreciation making imports dearer. This would then exacerbate CAD and fiscal deficit may shoot up further. Government seemingly has identified this threat, although very late, and has been exerting all its policies to achieve much stronger fiscal position. The finance ministry has undertaken open discussion on some critical aspects of forthcoming union budget which historically have never been discussed at public forums to the detail they have been discussed this time. The finance minister has sent out a strong message by hinting at non populous budget which is expected to address immediate concerns. The finance ministry is considering putting welfare, defense and road projects budgets on backburner by allocating about a trillion of rupees or nearly 1% of GDP lesser to these sectors.

Factoring in all the aforesaid developments and possibilities; we believe the investment in G-secs may still be rewarding although it doesn't appear as lucrative as it was a couple of months back. Now we need to find out whether a gilt fund is the best option to take exposure to sovereign debt. Let's see how gilt funds have performed across timeframes.

How Gilt Funds Have Fared?

	1 Month	2 Months	6 Months	1 Year	3 Years	5 Years	SD	Sharpe
Category Average -Short Term Gilt Funds	1.0	2.0	4.5	8.4	6.7	5.9	0.38	-0.24
Category Average -Long Term Gilt Funds	0.9	2.9	5.9	9.5	7.5	7.5	0.90	-0.02
I-Sec Si-BEX	0.8	1.7	4.5	9.3	7.1	8.0	0.32	0.04
I-Sec Li-BEX	1.2	3.7	7.7	11.8	9.2	8.4	1.22	0.10
I-Sec Composite Gilt Index	1.0	2.8	6.1	10.6	8.3	8.0	0.87	0.13

(*Risk is measured by Standard Deviation and **Risk-Adjusted Return is measured by Sharpe Ratio. The Sharpe Ratio is calculated over 3-Yr period assuming a risk-free rate of 7.38% p.a. for long term gilt funds and in case of short term gilt funds It is calculated on 2-Yr period assuming a risk free rate of 8.10%) (NAV Data as on February 1, 2013) (Returns are in % and absolute for the time period less than 1 year, otherwise compounded annualised)
(Source: ACE MF; PersonalFN Research)

The above given table suggests that average performance of gilt funds has been lacklustre as compared to that of their benchmark indices in the recent times. Both long term and short term gilt funds as a category have disappointed its investors over last 1, 3 and 5 years. This indicates that all gilt funds are not worth investing and you have to be very selective when you choose one for your portfolio.

Success Rate of Gilt Funds

Proportion of Funds outperforming the Benchmark Index	1 Month	2 Months	6 Months	1 Year	3 Years	5 Years
Long Term Gilt Funds	14.8%	11.1%	7.4%	14.8%	15.4%	47.8%
Short Term Gilt Funds	25.0%	62.5%	37.5%	12.5%	21.4%	8.3%

(Source: ACE MF; PersonalFN Research)

Dwelling deeper on performance of gilt funds, we discovered that they have been a lot inconsistent and have often underperformed their benchmark indices. This underperformance can mainly be attributed to brisk nature of rallies in G-secs. In other words, your success in gilt funds largely depends on how well you time your entry and exit. But this is not to say that you cannot participate in these rallies. Let's not forget about pure debt/income funds that look for opportunities in G-sec segment as well. Nothing other than its own mandate can stop a pure debt/income fund from investing in G-secs.

As per the latest disclosure of portfolios, on an average, long term income funds have about 55% exposure to G-secs as a percentage of their total portfolio. Maximum exposure taken by an income fund to G-secs has been around 98% while some income funds have a very negligible exposure to G-secs. It is the time to even consider their performance, before you decide to invest in a gilt fund.

Performance of Income Funds

	1 Month	2 Months	6 Months	1 Year	3 Years	5 Years	SD	Sharpe
Category Average -Short Term Income Funds	0.6	1.5	4.7	9.6	8.0	8.2	0.22	0.51
Category Average -Long Term Income Funds	0.5	2.0	5.3	9.7	7.9	7.3	0.57	0.10
Crisil Composite Bond Fund Index	0.6	1.8	4.9	9.1	7.3	6.7	0.35	-0.08
Crisil Short Term Bond Fund Index	0.6	1.3	4.3	8.9	7.3	7.5	0.18	0.11

(*Risk is measured by Standard Deviation and **Risk-Adjusted Return is measured by Sharpe Ratio. The sharp ratio calculated over 3-Yr period assuming a risk-free rate of 7.38% p.a. for long term income funds and in case of short term income funds it is calculated on 2-Yr period assuming a risk free rate of 8.10%) (NAV Data as on February 1, 2013) (Returns are in % and absolute for the time period less than 1 year, otherwise compounded annualised)
(Source: ACE MF; PersonalFN Research)

The table above suggests that in the long run, income funds have performed better than gilt funds on a risk adjusted basis. Furthermore, income funds have been less volatile as compared to gilt funds. The primary reason for superior risk adjusted performance has been the diversification across credit profiles and yields spreads and their flexibility to adjust maturity profile as per prevailing conditions.

Success Rate of Income Funds

Proportion of Funds outperforming the Benchmark Index	1 Month	2 Months	6 Months	1 Year	3 Years	5 Years
Long Term Gilt Funds	22.2%	54.7%	68.8%	76.6%	72.2%	68.2%
Short Term Gilt Funds	41.9%	76.7%	83.7%	93.0%	93.9%	80.8%

(Source: ACE MF; PersonalFN Research)

This shows that there are many Income funds that have managed to maintain consistency in their performance, as the proportion of funds outperforming the benchmark index across time periods has been significantly higher than that in the gilt funds.

End Note

While the recent cut in policy rates has not only come as a sentiment booster for the debt markets, but it has made the markets optimistic that RBI will gradually reduce rates in order to boost growth. On the other hand, the attractiveness of G-secs has reduced as most of the positives are already factored in. At the moment, rally in G-secs seems to have taken a breather although there still lays some scope for further rallies. Going forward, developments on the macro-economic front like fiscal consolidation, borrowing target, Current Account Deficit, Inflation, growth expectation etc would set the tone for G-secs. In that context, the forthcoming union budget for FY 2013-14 stands critical so as to obtain a clearer picture. Till then the markets may continue to remain watchful for further signals provided by the policy makers. In the run-up to the budget, the debt markets may move sideways with a bullish overhang, while the post budget numbers and developments will decide further course of debt markets.

As remains the questions of investing in gilt funds; we believe it would not be an ideal choice especially considering the limited scope for further appreciation in bond prices (and easing of yields). The performance of gilt funds in such conditions may not be encouraging either due to the high interest rate sensitivity it carries along.

On the other hand, performance of pure income funds looks more promising as they offer flexibility and diversification which may eventually lead to better income generation across interest rate cycle. A gilt fund would not be able to take advantage of credit spreads in corporate debt market but a pure income fund would have a flexibility to invest in G-secs as well as in corporate debt. Needless to say, selection of a right fund is the key to success.