An intensified interest in gilt funds has been one predictable outcome of the turmoil in debt funds and the general increase in uncertainty. However, rushing into these funds just on the basis of a few fleeting impressions is not a great idea even at the best of times. To do so in times like these is even less advisable.
The sudden interest of debt fund investors in gilt funds arises from two factors, one a push away from other types of debt funds and the other a pull towards gilt funds. Over the last few months, a series of debt funds that invest in corporate debt have had problems with credit quality and with liquidity. Gilt funds, since they invest only in government debt, are impervious to both. That's the push factor.
The pull factor comes from the sudden bonanza of high returns that gilt funds have seen over the last one year. As the RBI has lowered interest rates sharply, gilt funds' NAVs have risen sharply and their returns have shot up. At this point of time, the one-year average returns for gilt funds that invest in long-duration government securities is 15 per cent. To have such juicy returns in a category where there cannot be any credit or liquidity problems is simply too attractive for investors and for salespeople to not get excited.
However, the gilt fund story is replete with events like these. Time and again, whenever interest rates drop unexpectedly, a wave of excitement runs through the gilt fund universe and some investors try to jump on to a ship that has already sailed. That is not to say that gilt funds do not have a place in the investing universe. However, the nature of these returns spurts is such that investors who chase performance always get the short end of the stick, without fail.
To understand why, let's recap why gilt fund NAVs jump when interest rates fall, and to understand the phenomena, also why gilt fund NAVs crash when interest rates rise. Here's an illustration. Let's say you are holding a government bond that pays 7 per cent interest. At that point, if the RBI drops interest rates, you can expect that the government will start issuing fresh bonds which pay less, say 6 per cent. This means that the older bonds you are holding will be worth that much more. This will happen because anyone looking to invest in gilts will be willing to buy the 7 per cent ones at a price where their interest payout will be effectively 6 per cent. Ergo, they will be worth more by a ratio of 7/6. While this example calculation is somewhat simplistic, the underlying principle is exactly this.
So far, so good. However, now comes the sting in the tail. Remember, the event that drove this bonanza was a DROP in interest rates. That means that once the jump in NAVs is done, we are in a lower interest rate environment which will inevitably have a negative impact on the earnings of debt funds. Not just that, interest rates tend to oscillate around a certain point and a lower rate makes a higher rate in the future more probable.
Eventually, rates will rise and the opposite impact will happen. The lower rate leads to a one shot bonanza but is indicative of a negative trend in the economy, as you can well appreciate in the current situation. Mind you, given the Covid recession, it is entirely possible that there will yet be another round of cuts in the interest rates along with some bump in Gilt fund NAVs. I'm not making a prediction on that one way or the other.
All I'm saying is that the 14 to 15 per cent returns that Gilt funds appear to be generating are not a trend to be acted upon but a historical artifact. The right time to have invested in gilt funds was a few months ago, but that's not much use now, is it? If you are not already a seasoned gilt fund investor, then stay clear of trying to do some fancy timing in and out of such funds.