Even gilt funds can be volatile

In uncertain times, capital preservation is of paramount importance to any individual. If an investment that offers high returns also comes with a sovereign guarantee, isn’t that an ideal option? While that was the primary investment argument for gilt funds, the volatility in their returns has showed that gilt funds aren’t a risk-free option either.

Not only does investing in them require some sense of timing in the investor, only funds that can actively manage the maturity profile of the portfolio, and anticipate rate changes ahead of the cycle are able to benefit from the falling interest rates.

Over the past year, even as the equity market represented by bellwether indices such as the BSE Sensex and Nifty, lost close to 50 per cent, gilt funds, as a category, averaged returns of 11 per cent. However, this cloaks the substantial swings in the quarter-to-quarter returns, as interest rates have swung from a rising to a falling cycle.

Sharp divergence in yields


Gilt fund returns over the past year have varied sharply. The first half of 2008 saw very modest returns as interest rates were on a steady uptrend, given the central bank’s higher rate policy to quell inflation. As the prospect of the global slowdown took hold and India too began to feel its effects, the RBI began to cut its benchmark repo and reverse repo rates.

The reversal of the interest rate cycle which, in turn, contributed to higher gilt prices, was focussed in the last three months of 2008. Given the interest rate swings, 2008 saw yields from 10-year gilt rally to hit a 52-week high, before retracing to touch its yearly low on December 18, 2008, at 4.85 per cent.

Even as the returns from equity dwindled, gilt funds generated returns as high as 35 per cent (absolute) in three-month period between October and December 2008. But the return divergence was huge between funds with the topper being ICICI Pru Gilt Fund (35 per cent) and the fund with the least returns — DSP-BR G-Sec Fund-B (1.78 per cent). The divergences are explained mainly by the average maturity of the portfolio.

RBI’s rate-cutting spree


With the reversal in interest rates not clearly apparent until October 2008, for the major part of last year, debt and gilt fund managers kept the maturity profile of their gilt funds at or lower than four years. As the RBI began its rate-cutting spree, select funds anticipated a continued fall in interest rates and increased the average maturity of the schemes, raising it steadily from four years to 14 years in the last quarter of 2008.

In the recent past, gilt yields again spiked and reduced gilt fund returns with the government announcing a huge borrowing programme. Fund managers have again differed in handling this. Going by their cash positions it appears that some funds preferred to book profits on the rally. For instance, Birla Sun Life Gilt PF Plan Regular has increased its cash position from 5 per cent to 24 per cent over the past two months. On the other hand, funds such as ICICI Pru Gilt PF option, IDFC G-Sec, Principal G-Sec continued to increase the average maturity of the portfolio.

Funds with highest portfolio maturity took a sharper hit in their NAVs resulting from the spike in yields. In the past month, only eight of the 56 gilt funds have recorded positive returns.