In a falling interest rate regime, gilt and income funds are more attractive.
With equity and real estate markets taking a severe beating, investors are looking at investment avenues that could give them decent returns with minimal likelihood of capital erosion. While gold has been in vogue for sometime, it's a rather volatile asset class and subject to sharp swings in prices.
In the last two years, Fixed Maturity Plans (FMPs) were quite popular. However, due to new regulations, disclosure norms and a falling interest rate scenario, they are unattractive now. Even fixed deposits (FDs), which looked attractive for three-four months, are beginning to lose their sheen. Of course, for the risk-averse and senior citizens, FDs are still the best choice. For others, though, there are two interesting options in the debt space that have emerged stronger in the last few months – gilt and income funds.
Gilt funds invest in long-term government securities. These include central and state government dated securities and treasury bills. Since the investments are being made in government papers, the risk is almost zero. Income funds, on the other hand, have a mix of gilt, bonds of public sector units (PSUs) and corporate bonds in their portfolio. Obviously, they have the potential to deliver higher returns than gilt funds, but the risk is higher due to corporate papers.
There are three types of risks with these funds - credit risk, liquidity risk and interest rate risk.
Credit risk basically considers the repayment ability of the borrower. A high credit risk, therefore, implies that a borrower will not be able to repay the investors. In government securities, this risk is generally considered to be zero. In other types of fixed income investments, this risk is higher. In any economy, government securities are considered to be of the lowest risk. Therefore, a gilt fund is considered to be a far safer investment avenue than others.
Liquidity risk refers to the ability of the lender to sell the securities at any point in time. For instance, gold has high liquidity because it can be sold quickly. Sometimes, there are no potential buyers for the investment at a particular point in time. So, it would be sold at a discount to its actual value.
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Interest rate risk is caused by fluctuation in interest rates and has an impact on bond prices. There is an inverse relationship between interest rates and prices of securities. This gets reflected in government bonds first. When interest rates fall, the prices of bonds rise and vice versa. These funds deliver excellent returns in a falling interest rate scenario.
When compared to income funds, gilt funds have a zero credit risk portfolio and a very high liquidity portfolio because of active institutional participation for gilts. However, gills can be very volatile. The longer the maturity of gilt papers, the higher the gain or losses. Typically, corporate bonds have a life span of two to five years. For gilts, the maturity can even be 30 years.
Medium-term gilt funds are those that have gilts of four to six years maturities. Long-term gilt funds are those that have a sizeable exposure to gilts that have maturity of more than 10 years. But remember that the definition for medium- term and long-term though will vary across fund houses.
There was a sharp rise in bond prices over the last several months as RBI cut policy rates. With inflation now down to around 5 per cent, RBI could come up with another round of rate cuts. This could augur well for the bond markets.
A word of caution: There has been a decent correction in bond yields in the last several days. This could be mainly because of excessive government borrowing, profit booking by big treasury houses, oil prices going up and interest rate going upwards.
Given this volatility, investors must track interest rate changes and get their timing right. Once you have made double digit returns, it would pay to exit. At the same time, you must track the credit quality of the portfolio and ensure that you have invested in quality gilt and income funds.
That said, with developed economies in a recession and Indian economic growth slowing down, not just central banks around the world but also RBI will adopt a low interest rate regime to spur demand and buoy the economy. This scenario means good news for bond funds. For someone with a time horizon of 6 to 12 months, this could be a good bet.
The writer is director, MyFinancial Advisor