Saturday 18 August 2012

How to Invest in Gilt Funds?-VRK100-18Aug2012


How to Invest in Gilt Funds?




Rama Krishna Vadlamudi, HYDERABAD      18 August 2012


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:



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:




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%.

- - -

Appendix I - Returns of Select Gilt Mutual Funds

Name of the Scheme


AUM
NAV (Rs)
Crisil
Returns %
Rs crore
as on
Rank
2012*
2011
2010
2009
2008
2007
30-Jun-12
16-Aug-12

%
%
%
%
%
%
Birla Sun Life G-Sec fund Long-term
306
31.99
1
6.6
6.9
9.3
17.5
5.6
4.7
ICICI Pru Gilt Investment
222
37.18
2
6.4
5.9
5.2
(6.7)
36.5
8.4
IDFC G-Sec Investment Plan-A
19
21.11
2
7.2
9.5
3.4
(9.3)
30.9
6.3
Kotal Gilt Investment Regular
152
37.96
1
9.7
7.1
4.9
(5.0)
28.3
4.8
* 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
Best return %
Best return %
Worst return %
Worst
return %

Q2-2012
Q4-2008
Q1-2009
Q1-2007
Birla Sun Life G-Sec Fund Long-term
3.4
7.4
(2.1)
(1.1)
ICICI Pru Gilt Investment
3.6
31.2
(10.9)
(0.7)
IDFC G-Sec Investment Plan-A
4.5
25.5
(12.1)
(0.1)
Kotal Gilt Investment Regular
5.3
26.1
(11.0)
(1.6)
                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.

For author’s articles on financial markets, just click: www.scribd.com/vrk100

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