No Glitter Left In Gilt Funds

Gilt funds or Government securities funds, most liquid fund as compared to other debt instruments, is also going through a tough time. It has witnessed massive outflows of Rs6,305 crore since the start of 2018 till September, as per the data from Association of Mutual Funds in India (Amfi). Market experts attribute the outflows towards the interest rate cycle in India which has reversed with rates moving up sharply on the back of unfavorable macro situations impacting the domestic and global markets since September 2017. 

The 10-year benchmark bond yield has risen from 6.65 per cent in September 2017 to 7.98 as on October 12, 2018. That said, the ongoing US-China tariff war, rising crude prices, widening current account deficit (CAD), and emerging market sell-off has also added pressure on the currency. This has led to more outflows from the system as depreciating currency also reduces returns for foreign portfolio investors (FPI).

Bond Fury

The present outflow of gilt funds can be attributed to a host of factors. Worsening macroeconomic conditions at home, widening current account deficit, rising interest rates and falling currency over past one year has created a domino effect thereby hardening the bond yields. Prashant Pimple, Senior Fund Manager, Reliance Mutual Fund, said, “All unfavorable macro factors has resulted in yields hardening by over 125 – 150 basis points (bps) across the curve over last one year. Though fund managers have actively managed the interest rate volatility in gilt funds by reducing scheme duration at the right time, investors have redeemed and stayed away from the gilt funds in a rising yield scenario.” 

As far as rate hikes go, RBI had raised rates by 50 bps earlier this year while keeping the stance “neutral”. However in the latest policy meet in October 2018, it changed the stance to “calibrated tightening” signaling that the rates may rise in future. Market experts believe that markets have already discounted about 50 bps more hike in next one year. This expectation of further rate hikes has also pushed yields higher leading to fall in price. Dheeraj Singh, Head of Investments, Taurus Asset Management, said, “These price declines are instantaneously captured in the net asset value (NAV) of the funds which would have shown sluggish growth or even declines in some cases. This relative underperformance of the funds may, therefore, have been a trigger for the outflow from the gilt funds.”

Bond (or fixed income securities) prices move inversely to interest rates. As a result, when the interest rates rise, prices fall. Indian markets which have already been witnessing rising interest rate environment for sometime now and therefore, most bonds have seen a decline in their prices. Lakshmi Iyer, CIO (Debt) & Head (Products), Kotak Mutual Fund, highlighted “In last 12 months, we have seen sovereign rates up north of 1-1.5 per cent. This has unnerved the investors and hence we are seeing outflows. Alongside, we have also seen risk on assets like equities, which did reasonably well over the past three to five years. It may also be possible that some monies may have switched asset classes from debt to equities.” 

Understanding Gilt Funds 

Gilt funds are those where the underlying investments are made in sovereign securities – i.e. those issued by the central and state governments. There are mainly two type of gilt funds i.e actively and passively managed. The actively managed funds includes  long and short duration gilt funds, while passively managed funds includes 10-year constant maturity gilt funds and gilt ETF, which may vary between eight and 13 years. Different kind of investors like retirement funds, corporates, high net-worth individual (HNI) and retail investors invest in gilt funds for a long-term investment horizon and to avoid any credit risk. Gilt fund forms an integral part of any Retail investors’ asset allocation from safety and longevity perspective,” explained Pimple.

As gilt funds invest only in government securities, it doesn’t have credit risk, unlike a corporate that might face the risk of default in future. “This category is suited to those investors who do not want to assume any credit risk, but are ok to ride through interest rate cycles. Its asset under management (AUM) in the mutual fund industry is `8,000 crore and is largely owned by retail/HNI kind of investors.” explained Iyer.  As these funds consist of government bonds, their risk of default is zero given the advantage of sovereign guarantee. However, that doesn’t mean they are completely risk free. Singh opined, “The risk of credit defaults (like the one we have witnessed recently in the case of IL&FS) is effectively eliminated. However, the securities do carry a price risk. Hence the NAV of gilt funds could go up or down depending on how prices of the underlying securities move in the market.”

Investors Plan

Gilt funds are actually meant for investors who can take a call on the interest rate cycle and time their entry and exit based on such cycles. They are nothing but a tactical play of falling interest rates, the moment interest rate starts moving up, it goes out of flavor. Pankaj Pathak-Fixed Income, Quantum Mutual Fund, said, “Normal investors usually do not track the interest rate cycles very closely and are mostly unable to time the market optimally. If an investor has the appetite to take interest rate risk and can hold their investment for a longer time frame, they can invest in dynamic bond funds.”  With the rise in interest rates, prices of bonds tend to fall and the same is reflected in the NAVs too. “The gilt category, therefore, has underperformed categories like liquid funds over one, two and selectively in three-year horizons too. Thus it has impacted investors with sub-optimal returns due to rising interest rates,” pointed out Iyer. (See Gilt funds returns Table)

Whether to stay put or come out of the gilt funds are the questions investors are battling with. “When yields rise, prices of bonds fall making it unattractive for investors to stay invested in long-duration funds like gilt funds hence we have seen a reallocation of gilt investments into other fixed income mutual fund schemes with low duration. Typically investors relook at long duration funds like gilt funds once growth peaks out and inflation stabilises.” agreed Pimple.  As per many fund managers, dynamic bond funds have that flexibility to invest across the maturity curve. Under such fund, depending on the interest rate cycle, the fund manager changes the maturity profile of the portfolio. “If interest rates are on the rise, they reduce the portfolio maturity to make the portfolio NAV less sensitive to the interest rate changes. And if interest rates are expected to fall, they increase the portfolio maturity to enhance returns,” explained Pathak.

Pain Of Excessive Pricing

Given that interest rates are at elevated levels, one could consider staggered investments at this juncture. Iyer explained, “Bond yields would still take time to stabilise due to currency/crude movements and rise in global bond yields. Hence yields may not be in a hurry to cool off making staggered investments a potent option in such markets.” One positive factor for the yield curve has been the continuation of open market operations (OMO) purchases by RBI in response to tight system liquidity. As RBI purchases government securities from the market, it releases liquidity into the market. “RBI has conducted five OMOs in last five months’ worth Rs50,000 crore and has announced another Rs36,000 crore for October. We expect it to continue with infusing durable liquidity into the system, adding to approximately Rs1,25,000 – Rs1,50,000 crore of OMO purchases for Financial Year 2019,” said Pimple.

Fund managers believe a lot of fear and cautiousness has already been built in the price. Market yields and liquidity have already tightened in anticipation of aggressive rate hikes. Although timely and strong intervention by regulators and government is expected to restore calm in the market quickly, however, it will take some time to see whether any underlying apprehensions are still playing out. Pimple further said, “It’s just a question of time whether the underlying economy will remain supportive of the tightened financial conditions or the rate markets will have to readjust itself to the nascent growth recovery.”

Fast Forward

Given the situation, timing investments based on perception of economic cycles is not recommended. It is also upto the investors to understand track record of the fund.  “It is impossible to gauge when the economic cycle has turned. It is better to follow a stable asset allocation policy based on one’s risk appetite and needs. The markets will ensure that the rest is taken care off,” said Singh.  It is rather obvious that gilt funds runaway growth will take some time to return, meanwhile, for the investors, it is very important to park their funds which prioritise safety and high liquidity as well as staying true to the investment objective of the fund.

himali@outlookindia.com