GILT FUND RETURNS
Fund Managers managing Gilts don’t need to worry about credit risk as the counterparty is the Indian Government – therefore they focus on active management of the “duration/ maturity” – that is, the average age till maturity of the bonds in the portfolio. Remember – Returns from any debt funds including Gilts turn negative when interest rates rise as the value of the portfolio paying lets say an interest of 8% has to fall if one can get higher rates in the market, lets say 8.25%, for the same money!.
As India gilt yields rose, Gilt funds, in the last one year, gave negative returns of (-)0.63% across 28 gilt schemes in the industry.
For a wide variety of reasons, covered in our earlier posts, debt yields were tightening and the 10 year has risen by almost 150 basis points from its lows a couple of years earlier. The conventional view, and correctly so, was to stay away from this category until interest rates keep moving up.
WHAT IS CHANGING
There is increasing consensus that the Federal Reserve may not be able to push the yields above 3.5% and most of the 3 hikes until next year seem to have been factored in – and remember all of this will happen only if the growth engine in the US continues to power on. However, higher prices for crude, growth dampening due to Brexit due March 19 (and German elections soon which may throw a spanner in the works) and most importantly, the impact of earlier tax cuts in the US waning off – are all expected to keep the US 10 year under check. On the other hand, the continuing low Indian inflation (despite some later pickup as base effects wear off and the higher crude prices express themselves), despite a weaker currency, is unlikely to push yields beyond 8.5% which seems to be the highest potential yield over the foreseeable future. While government borrowings may play spoilsport if these move out of line with budgeted numbers, the impact is likely to be curtailed.
In effect, there is a lot at play that may move yields both sides but the downside risks seem relatively capped and hence a closer look may be warranted.
SIPs : The IDEAL WAY
Gilt Funds have an underlying yield of 8% which is attractive for conservative investors not looking at near term liquidity AND don’t want large risk in their portfolio either. The challenge however is in taking a view on interest rates – which as of now appears unclear.
If 10 year yields were to however go back to lets say 7% over the next 2 years, there would be a lovely capital appreciation to be made as this alone can add upto 3% in capital appreciation per year over and above the 8% yield. This implies a return of close to 11% pre tax.
Since the volatility may be too much to digest for some investors, we suggest a phased approach to entering our recommended Gilt funds via the SIP route for those who find these returns attractive and agree with the above hypothesis. A staggered approach may allow the entire interest rate cycle to play out without causing too much initial damage and then start generating returns over a period of time as the cycle smoothens out.
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