Why did gilt funds provide more returns last year than income funds? Theoretically, shouldn't it be the opposite?
—K. T. S. Raman
Last year's performance by gilt funds was not an aberration. These schemes will outperform income schemes in a situation where interest rates are falling, as was the case last year. Government securities give lower interest, as they are sovereign securities and have theoretically zero risk. Lower risk means lower returns, and so these instruments give lower interest as compared to corporate bonds. Even the best corporates have a higher risk of default than the government, so they pay a higher interest on their fixed-income securities.
Based on this higher interest income alone, one would expect that income funds would generate higher returns as compared to gilt funds, since bond funds have more exposure to corporate debt than to gilts. But the factor you have missed out is that gilts are more liquid than corporate bonds. This leads to greater price variation and this throws up trading opportunities. The higher price variation coupled with trading generates higher returns for gilt funds as compared to income funds. Thus, in the year-to-date ending September 30, 2003, the average gilt fund has returned 8.40 per cent. In comparison, the average bond fund in the same period has generated 6.12 per cent only.
Another equally significant reason for the higher returns of gilt funds is their higher average maturity. Longer maturity bonds are more sensitive to fluctuations in interest rates. Even within bond funds, all other things remaining constant, the fund with higher gilt exposure and portfolio maturity will do better. But do note that this applies to a falling interest rate regime. When interest rates move up (i.e. bond prices move down) gilts will take a greater hit as a result of their greater liquidity.
This article was originally published on November 12, 2003.
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