If the current year has been sensational for bond funds, it has been Manna from Heaven for gilt fund investors! Government security funds are up an average 22.25 per cent for the year while debt funds are a distant second at 15.74 per cent. With their investments in longer maturity sovereign bonds that also offer high liquidity, gilt funds have aggressively leveraged the bull-run on the Bond Street. While there are hardly any corporate bonds beyond five years, all benchmark G-Secs are at the long-end with maturity ranging up to 25 years. Thus, this facilitates better returns for gilt funds as longer-maturity bonds log in higher capital appreciation. Further, lower expenses for gilt funds perk up gains since high liquidity of the portfolio pulls down transaction costs.
However, after the rate cuts last week, interest rates are now expected to stabilise with range-bound bond prices. This will certainly restrict capital gains, which have made a substantial contribution to returns in the current calendar and hence, focus could shift back to interest income. Bond funds, with substantial investment in corporate paper, earn a larger interest income since these instruments offer a higher coupon (vis-à-vis gilts) for their credit risk.
For instance, the current yield on a Triple A corporate bond could vary anywhere between 8.6 to 9.2 per cent with higher return for less liquid securities. On the other hand, the prevailing yield on a five-year sovereign bond is only 7.25 per cent, which translates into a spread of at least 136 basis points. Further, the maximum return from the gilt basket is 9.83 per cent for the 25-year bond but even G-Sec funds very rarely venture into such long maturity papers. On the contrary, debt funds have the leeway to boost returns by not only investing in AAA but even lower rated debentures that offer higher coupon with dilution in credit quality.
So, will bond funds now race ahead of gilt funds on the back of a higher corporate yield coupled with some capital gains as investors chase the high spread? "If interest rates remain stable (and I think so), then bond funds have to outperform gilts simply because spreads on corporate bonds will offset the expense ratio advantage (for gilt funds)," says Vineet Udeshie at Alliance Capital AMC. Points out Shailendra Jhingan at Birla Sunlife, "There is a more compelling case for income funds at this stage where spreads are so high especially on AA papers."
However, not all fund managers agree and in fact expect lower appetite for corporate bonds in a faltering economy. Thus, the rally may not even percolate to a large section of AAA bonds, let alone lower rated papers. "We believe that corporate securities may not out-perform underlying gilts as the corporate spread is expected to widen due to deteriorating credit environment. So far, we have seen five AAA downgrades and there could be more in AA+ and AA buckets in near future. Thus, in this scenario, gilt funds are expected to do well due to their liquidity and lower expenses," says Dhawal Dalal at DSPML AMC. Seconds Nilesh Shah at Templeton, "The problem of credit migration (more downgrades) will depress return for probably second half of current year, say till March 2002. Thereafter (i.e. after pricing in the impact of all the credit migration) bond funds will do well."
For instance, IDBI bonds have not given any returns for the last six months. A typical 5-year IDBI bond has lost 200 basis points after the downgrade, which means approximately Rs 8 for a six-month period. On the other hand, coupon income has been around Rs 4 to 5 in the same duration, which has actually resulted in a negative total return of Rs 3 to Rs 4.
Thus, apart from a higher yield, whether bond funds will beat gilts depends on the quantum of fresh investments in corporate bonds. "We are seeing money return to income funds post credit policy. If this is significant and a large part of this goes to buy corporate bonds, spreads would shrink and hence bond funds will outperform (as prices go up)," says Udeshie. Mutual funds are staple investors here as banks largely avoid company debentures due to stringent prudential norms and lack of adequate capital to make a 100 per cent provision for these investments.
The Road Ahead
Well, investors now have to choose between credit and interest rate risks. When investing in a bond scheme, investors must discern the portfolio to ensure that the fund has sizeable investments in top rated corporate bonds and does not aggressively dabble in poor quality papers. While capital loss can still be recouped, credit default has to be eventually written off, thus causing an irreparable damage to NAV. On the other hand, if you are opting for gilt funds, invest only for the long haul, as they can be volatile in the short-term. Anyway, there is a strong case for gilt funds today since they are devoid of credit risk.
Last but not the least; while most fund managers expect a stable interest rate scenario, interest rates could still change at a rapid pace. "Volatility in developing markets like ours is here to stay. The active trading by most participants including public sector banks and insurance companies ensures heightened volatility,'' points out Jhingan. Adds Ramgopal Kundurthi at IL&FS AMC, "While stable markets would increase returns on bonds but I guess there is always some volatility over medium term. It is here I expect gilts to outperform bonds since their (gilts) higher duration provides better returns in a rising market and better liquidity helps cushion the fall in falling markets."