The Hindu Business Line : Fund Talk

From the tables you published last week, I saw that some gilt funds had given a return of as much as 40 per cent in 2008. Can I switch from equity funds into gilt funds to recoup some of the losses I made last year?

We would advocate that you stick to a fixed allocation between equity and debt investments for your portfolio. Within each portion, allocate a certain percentage to aggressive and passive options, depending on your risk profile. Do not switch from equity to debt funds in an effort to “chase” returns, as that may prompt you to move into each asset at the wrong time.

Right now, you can invest a portion of your debt fund portfolio in gilt funds. But do note that the returns from gilt funds were exceptional in the past three months and may not be repeated. They may deliver reasonable gains, but of a much lower order over the next one year. Debt and gilt funds, over a five-year timeframe, cannot match returns that are possible from equity funds.

The statement “Past performance is not indicative of future returns” applies as much to long-term debt and gilt funds as it does to equity funds. Gilt funds and long-term debt funds perform well when bond prices are steadily rising, boosting their NAVs.

Interest rate expectations

Gilt price movements, in turn, are directly linked to interest rate expectations in the market. When markets expect interest rates to fall, they mark up the prices of existing bonds or gilts that carry a higher coupon rate. When they expect rates to rise, they mark down the prices of gilts and bonds.

Prices of securities that have longer maturity periods gain or lose more in response to interest rate changes than short term ones. Therefore, gilt and long term bond funds tend to deliver their best performance ahead of a reversal in the interest rate cycle, from rising rates to declining rates.

That is what happened between October 2008 and early January 2009. As the RBI moved from a tightening interest rate bias to a loosening one, bond and gilt yields fell sharply. The yield on the 10-year government bond, for instance, corrected from 7.45 per cent to close to 5 per cent between October and end-2008 even as its prices rose sharply.

This period saw exceptional returns on gilt and bond funds, as the “surprise element” added to the price gains. With the RBI already midway in a reducing interest rate cycle, the gains on gilt and bonds may turn more muted in the months ahead. After their earlier rally, gilt funds have already given up some of their exceptional gains in the past fortnight, with the average gilt fund actually seeing its NAV drop by about 4 per cent in this period.

With inflation on a downswing and the economy in the throes of a slowdown, the softening trend in interest rates does look imminent. That suggests reasonable returns from gilt and bond funds. But the strong rally in bonds over the past three months already captures some of this fall, and gains from here on may be more moderate. Going forward, long term debt funds may deliver returns that are better than gilt funds, as the coupons they earn on their portfolio remain much higher than gilt funds.

Not risk-free

So should you invest in a gilt fund or bond fund today? You can go ahead, if you have an appetite for risk. But make sure that you do that only after you lock into other fixed income options such as fixed deposits. Be aware that long term bond and gilt funds, unlike fixed deposits, are not risk-free.

Both gilt and bond funds carry a price risk. If interest rates rise, instead of falling as expected, you may face an erosion in the NAV of the fund you hold. In the case of debt funds, there is also the additional credit risk on the companies held in the fund’s portfolio. Sticking to funds with Triple-A rated exposures may be the safer course.

AARATI KRISHNAN

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