As St bleeds, gilt funds gain golden hue

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An investment in a medium- or long-term gilt fund last month would have fetched you a return of 3.40% by now — a whopping 40% or so, annualised.

Sure, the stock markets are forbiddingly volatile. But, you’ll agree, one could have done better than hold on to all that cash.
It’s not too late even now.

Interest rates are widely expected to start falling from next year.
If they do, returns on gilt fund investments will rise.
Intrigued? Here’s how it works:

-Gilt yields and interest rates move in the same direction. So, when interest rates start coming off, yields cannot but follow;

-On the other hand, gilt prices move in a direction opposite to that of yields. Hence, when yields start falling, gilt prices start rising;

-When gilt prices start moving up, so do the net asset values (NAVs) of the gilt funds which have invested in these instruments;

-You gain, because you had invested in the funds when their NAVs were quoting lower.

Gilt funds are a type of mutual funds that invest in government securities — better known as gilts — and money market
instruments.

In a scenario where market risk has impacted equity schemes, it is always advisable to reshuffle and diversify one’s portfolios to include gilt funds, if not gilts per se.

Experts typically recommend younger investors to allocate up to 75% of their investible surplus to equity and the rest to debt, and rebalance the portfolio in tandem with their risk appetite as they grow older.

“In the last two weeks, I have started recommending gilt funds to my clients because interest rates will start turning down, making gilts a more lucrative investible option. Over the next 1-2 years, gilt is going to give much better returns,” said Suresh Sadagopan, who runs Ladder 7 Financial Services.

According to experts, gilt funds have given an average 7-8% pre-tax over the past two years or so that the RBI has been hiking rates  — paltry by most standards.

It may be time for a course reversal, given that one-month returns have shot above 3% of late.

In fact, in the last one month, medium and long-term gilt funds have emerged the best performers and the category average return of the best gilt funds has touched as much as 4.47%, according to data from Value Research Online.

Gilt yields started falling after the Reserve Bank of India (RBI) announced open market operation (OMO) purchase of gilts from mid-November. OMO purchases help infuse liquidity into the system and thereby douse yields.

In the last one month, the yield on the 10-year benchmark gilt (8.79%-2021) has fallen around 30 basis points.

“Since the RBI has signalled a pause in its interest rate hiking cycle, taking exposure to gilt funds now is the best investment decision one could take,” said K Ramanathan, chief investment officer at ING Mutual Fund.

“In addition, the domestic growth rate has also dropped, as indicated in the index of industrial production and core industry growth numbers,” Ramanathan said.

Ramanathan believes that by December 2012, gilt funds will outperform all fund categories. “The average returns that a gilt fund gives are typically in the early double digits. To make good returns, one should be invested for at least a year and not less than that,” he said.

The market expects the RBI will first go for a cut in the cash reserve ratio (CRR) before cutting the repo rate. CRR is the amount of funds banks must maintain with the RBI with reference to their net demand and time liabilities.

“We can expect a 50 basis points CRR cut by early next year, which will help infuse about `30,000 crore in the system. The infused liquidity will create demand for gilts, due to which yields will fall further from current levels,” said Murthy Nagarajan, head - fixed income, Tata Mutual Fund.

One basis point is equivalent to 0.01% or a hundredth of a percentage point.