Gilts fast losing glitter

By Dhirendra Kumar

Besides gold, gilt is the other category that has caught the fascination of investors. While gold has grabbed attention due to its nature as an asset of the last resort, gilt's reasons for coming into the limelight is its sudden resurgence in performance. In 2008, when equity was coping with negative returns, gilt funds were able to deliver a return of 25.33%. For most of 2008, gilt funds were either non-performers or their usual selves. But this changed when RBI got into action to combat the liquidity crisis with a series of rapid cuts in the repo rate between October and December 2008. With a cut of 2.5% in repo rate and a cut of 3.5% in Cash Reserve Ratio, gilts funds' returns shot through the roof. This over performance was due to 20.69% returns in the last quarter in particular with 12.43% return from just the month of December 2008.

To understand the reason behind this sudden resurgence of gilt funds, we first have to understand what gilt funds are. They are mutual funds that predominantly invest in government securities (G-Secs). Unlike conventional debt funds that invest in debt instruments across the board, gilt funds target just a given category of debt instruments i.e. G-Secs. These are securities issued by RBI on behalf of the government. Being sovereign paper, they do not expose investors to credit risk. They are also the most heavily-traded paper in the market. Banks, insurance companies and provident funds invest in them for safety and statutory reasons. This also ensures adequate liquidity and in turn volatility for G-secs in the market.

Since the market for G-Secs is largely dominated by institutional investors, gilt funds offer retail investors a convenient means to invest in G-Secs. For gilt funds the main source of their income, apart from earning fixed interest, is from the trading gains that accrue due to trading in gilts. With inflation going southward from its peak value in August, for any gilt fund manager it was a foregone conclusion that policy rates would be heading down too. Hence it was only a matter of 'when' not 'if'. Gilt fund managers bought into G-Secs of higher and higher maturity.

Because rate cuts make the older G-Secs with higher interest rates more attractive, with the rise in demand their prices go off the charts enabling the fund manager to make trading profits by selling them. That's exactly what happened: the 10-year benchmark paper's yield (as there is negative correlation between yield and prices) dropped over 320 basis points between October and December 2008. Gilt funds turned in astounding returns of up to 35% in the quarter. These fabulous gains got investors excited. Gilts looked like the obvious way to recoup losses made in equity. Gilts funds assets almost doubled from Rs 2,500 crore in November to Rs 4,800 crore at the end of February, 2009. Falling inflation numbers and increasing uncertainty in the economy forced the RBI to announce a cut in the repo rate by 50 bps on March 4, 2009. But to the dismay of many, the yields refused to budge in response. The gains expected by investors were nowhere to be seen. The reason for this was the on going borrowing programme of the government. Till March 31, 2009, the government needs another Rs 34,000 crore to meet with the current year's budget deficit. In normal course the government would have to issue new bonds to fill this gap. In anticipation of this flood of new bonds, the markets are shying away from any new purchases. The result is that the yield is going up rather than falling. Between March 4, 2009 and March 12, 2009 the yields have gone up by 10%. RBI is on a war footing to soften the yields from this level but the supply of new issue is just too great to provide any relief.

The gilt funds performance for the week ended March 6, 2009 has been lacklustre. The returns of the gilts funds over last one week have been -1.09% (March 1-6, 2009). Furthermore, the fiscal stimulus announced by the government to kick-start the economy has done nothing to help the gilt funds. The only thing it has done for the money market is that it has fuelled a growing apprehension about how the government would be able to finance all the recent expenses. The 10-year G-Sec from the low of 5.02% in January, 2008 has gained 39.86% to touch 7.03% on March 12, 2009. Hence after the spectacular performance in December, most gilt funds are languishing in red. For January and February, gilt funds turned in -6.23 and -1.74% respectively.

Looking at the month-on-month return of gilt funds, it may seem that these have become too risky an investment option. But the fact is this is how gilt funds have always been. Back in 2001 and 2002 when rates were coming down gilts funds were the prime beneficiary. Their returns were comparable with the equity funds returns, but the moment there is a long period of inactivity in the interest rate or if rates are on a upward trend then gilts funds become a very dull investment option. Many a time, interest rates will change in unpredictable ways. At other times, interest rates may be predictable, but their impact on bond prices may hold surprises. There are plenty of funds that increase or decrease maturity violently at the slightest sign-real or imagined-of rate movements. A gilt fund managers' job is to take calls on rates and yields but that doesn't mean that a call has to be taken all the time. Nor does it mean that maturity must always be jerked from one extreme to the other whenever a call is taken. In these unpredictable times, circumspect beliefs and moderation of action is the path that takes care of investors' interests the best. Thus, we have selected three funds that are not the top-performers of the past few months. Nor are they the biggest. But we believe that they fit the above profile well.

It is important to always keep in mind that notwithstanding the credit quality, medium and long-term gilt funds are the most unpredictable animals in the fixed-income zoo. Invest at least for a year and be prepared for short-term shocks.


The author is CEO, Value Research


Canara Robeco Gilt PGS

Over the last few years, Canara Robeco Gilt PGS has established itself as one of the steadier performers of this category. In the five years since 2004, it has more than kept pace with its peers, either outperforming the average gilt fund handsomely, or lagging by a small margin. All in all, Rs 1 lakh invested in this fund would be Rs 1.42 lakh today, as against Rs 1.26 lakh for the average gilt fund. In fixed income terms that's a significant difference. During 2008, which has been a signature year for gilt funds, the fund's returns were an astounding 35.17%, which gave it the 6th rank for the year. However, what impressed us more was the fund's progression through what was an exceptionally turbulent year. During the first three quarters, the fund was ahead of the category average by an average of 2.64% every quarter, adding up to a cumulative lead of 7.92%. In the last quarter, it exploited RBI's interest rate bonanza just as well as the rest, with returns of 20.63% for the three months.

However, the fact that, the fund matched the average and did not do as well as the top funds during the quarter, looks like a positive sign to us. When we observe the maturity changes that fund manager Ritesh Jain affected during that phase, we see a degree of conservatism which we like. During the October liquidity crisis, the fund manager dropped the maturity. When RBI unexpectedly softened rates in November, the fund gained less than its peers.

Investors shouldn't mind this because dropping yields during the global liquidity crisis was a safer course of action. The point is proven when we look at how things played out in 2009. All gilt funds have suffered during this period. However, the funds' lower maturity has helped in containing the downside well in January and February 2009. Canara Robeco Gilt PGS was down by 3.01% and 0.76%, while the category was down by 6.23% and 1.74% (January and February) respectively. It must be noted that the fund's 2008 performance was at the hands of two fund managers. Suman Prasad was at the helm till June 2008, when Ritesh Jain took over. Jain came from Kotak (KOTAKBANK.NS : 274 -27.7) Mutual, where he ran Kotak Floater LT, Kotak Flexi Debt, Kotak Gilt Inv Regular and Kotak Balance during his 3-year stint.


ICICI (ICICIBANK.NS : 345.45 -39.75) Prudential Gilt Investment PF

Make no mistake, this is an aggressive fund. Fund manager Rahul Goswami has been running the show since October 2005 and his reign has been marked by generally long maturities, aggressive calls and quick movements. For the most part, this has worked out well, especially in the recent past. While 2008 was a great year for practically all gilt funds, this fund was shining much brighter than all others. During the year, its returns were 45.44%, far higher than the average of 24.94%. Even the number two fund was way behind at 36.98%.

The returns were a result of a characteristically nimble action on the maturity front. When the yield came down from 9.33% (July 2008) to 8.67% (August 2008), the fund increased its maturity profile from 9 months to 12 years. As interest rates kept falling further, Goswami increased maturity further to 18.16 years by the end of December 2008. At that point, the average maturity of the other funds of the category was an average of 13.70 years. This gap is what produced the superb performance for the fund.

However, the next two months showed investors the flip side of the approach. In January and February 2009, the fund manager expected the interest rate to go down further and increased the average maturity to 20.19 years (February) while its peers reduced it to 10.82 years. However, when the yield moved up from 5.25% (December) to 6.40% (February) the fund lost money. Commendably, its losses in January and February were in line with the category average (-6.63% vs -6.23% and -2.07% vs -1.74%). During January and February, the fund held a rank of 18 out of 47 funds in the category. Still, this entire episode underscores the importance of scoring big whenever it's possible. Because the fund exploited 2008 so well, its very much top of the heap over the entire period (January 2008 to February 2009). Over a longer term too, this is an outperformer. Since its launch in November 2003, there has never been a year when its returns were less than the category average.

The bottom-line is that this is a smartly-run fund, albeit an aggressive one. If this is the profile you are looking for then ICICI PRU GILT Investment PF is a first rate choice.


Templeton India GSF Long-term

Templeton IGSF Long-Term is a gilt fund that has managed to implement a remarkably balanced approach. It has never raced ahead leaving other funds in the dust; but it has never suffered a severe reversal either. In the seven years since it was launched, its annual returns have always been ahead of the category average. Also, they've always been positive-even in 2004 when the going was tough and the category as a whole lost money (-0.40%), this fund made a reasonable gain of 2.95%.

The most interesting fact about this fund's performance history is that it has done well during both rising and falling interest rate regimes. Between February and July 2008 the yield of the 10-year benchmark paper rose from 7.56% to 9.33%, the fund generated on an average 0.20% return monthly while the category was down with a negative 0.19% return. The average maturity period of the fund was 3.40 years vis- -vis category's 4.09 years. From August the yield started declining and by the end of December it reached 5.25%. The fund gained 4.06% return in comparison to category 4.34%. The average maturity of the fund was 5 years while its category was at 8.74 years. Again in January 2009 when the yield rose to 6.21%, the fund was down by 0.35%, while its category was down 6.23%. The average maturity of the fund was 7.61 years while the category was 12.54 years. Incidentally, during this period (in June 2008), Vivek Ahuja replaced Ninad Deshpande as the fund manager. Deshpande had been at the helm for almost two years.

In its seven years, this fund has reported a maturity less than its stated three years for 13 months. This has helped it handle rising interest rate situations better than many others in the category. The conservative attitude has also meant that the fund exploited the 2008 Q4 bonanza less effectively than category leaders. However, returns for 2008 were still a solid 27.65%, well ahead of the category's 24.94%.

For investors who'd like to balance caution and aggression, Templeton IGSF Long-Term is ideally suited for trying out the occasionally troublesome category of gilt funds. It manages to deliver the better aspects of gilts while filtering out the worst.