Fund Call . What’s in store for gilt funds?

Bond markets have had a rocky start this year, with the yield on 10-year government bond swinging wildly between 6 per cent and 6.5 per cent since January. While bond prices rallied sharply in the beginning of March (10-year bond yield at 6 per cent levels), they fell notably by mid-April (yield at 6.5 per cent levels). Over the past few sessions, bond prices have risen again (yield at 6.1 per cent levels), with RBI’s recent measures.

Such wild gyrations in bond yields have left investors in a lurch. Given that longer-duration bonds are more sensitive to interest-rate movements, investors in gilt funds have been feeling the heat.

Given the uncertainty over bond yields in the months ahead, volatility in gilt fund returns could persist. And hence, long-duration gilt funds may not be for the faint-hearted conservative investors.

Only investors with a long-term horizon of 3-5 years, with an ability to weather interim shocks can invest a small portion of their debt investments in gilt funds.

Uncertainty galore

The focus of the Indian bond market until as recent as February remained on domestic factors such as elevated inflation and understated fiscal deficit.

But the Covid-19-led turbulence over the past two months has wreaked havoc not only in the Indian debt market but across bond markets worldwide.

Foreign portfolio investors (FPIs) have pulled out close to ₹79,000 crore from Indian bond markets so far this year. This, coupled with a weak appetite domestically for government bonds (from banks), has impacted our bond markets significantly.

On March 27, the RBI announced a slew of liquidity measures and also cut repo rate steeply by 75 bps to 4.4 per cent. Yet, yield on the 10-year government bond shot up to 6.5 per cent levels by mid-April. There were several reasons for this. One, demand from foreign investors has been very tepid. FPIs pulled out about ₹60,300 crore from Indian debt in March alone, and are utilising just 38 per cent of their investment limits (only 1 per cent in State Development Loans).

Two, risk-aversion among domestic banks has kept them wary of investing in government bonds, too (fearing rise in yields and treasury losses).

Three, the Centre had front-loaded its borrowing for FY21 (budgeted at ₹7.8-lakh crore), borrowing 63 per cent of the annual target in the first half.

The Centre had also announced ₹1.7-lakh crore of fiscal stimulus to address the Covid-led turmoil (of which only ₹73,000 crore is reportedly new). There are wide expectations of a second package that could be much larger, to aid the ailing economy.

With the Centre’s estimated gross borrowings figure of ₹7.8-lakh crore for FY21 already understated, oversupply of bonds owing to the additional fiscal stimulus package is hanging as a sword of Damocles over bond markets. Whether the RBI comes forward to directly monetise the Centre’s debt (subscribing to the primary issuance of Central government securities) needs to be seen. Hence, despite the RBI’s continual easing policies and liquidity measures, 10-year government bond yield could remain elevated, with wild swings in the near term.

What for gilt funds

Long-duration gilt funds are more sensitive to interest-rate movements. Hence, given the uncertainty over the trajectory of bond yields in the coming months, investors must tread with caution.

While long-duration gilt funds made a comeback in 2019, delivering 10-11 per cent average return, the road ahead could be bumpy.

Gilt funds, year-to-date, have delivered 4-6 per cent returns, but amid a lot of volatility.

Over a longer three-, five- and 10-year periods, gilt funds have delivered 8-8.5 per cent CAGR returns. While the returns may appear attractive over the long run, investors have to be prepared to tide over short-term volatilities that can be significant.

For instance, while in the boom years of 2014 and 2016, gilt funds delivered strong 16-17 per cent returns, the funds delivered a lacklustre performance in 2017, reporting about 2 per cent average returns.

While returns improved marginally in 2016 (to 5-6 per cent), they went up notably in 2019.

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