In case your bond fund has given super-normal returns, just check out the portfolio for gilt investments. Fund managers are increasingly turning to government securities or gilt's to manage the sedate bond funds. Gilt's, by virtue of their high liquidity, are most sensitive to interest rate changes. Thus, in the event of interest rate hike, a high gilt exposure can tear apart the returns from a bond fund. While a majority of debt funds have kept their gilt exposure below 35%, there are others with a substantially large investment locked in this volatile pack. No wonder, they have emerged as gilt funds in the garb of debt schemes and could prove to be a disastrous investment for the unknown investor. So far, with a string of interest rate cuts in recent times, these funds have posted impressive returns and can easily attract lay investors.
Consider PNB Debt, the open-end medium-term bond fund from PNB Mutual Fund. The fund had a 70% exposure to sovereign bonds on March 31, 2001 though on occasions, it has even crossed 90%. Worse, most of the investments have been in medium to-longer dated gilt's, which are highly susceptible to interest rate changes. While the fund ranks number one for the one-year period with an eye-popping return since launch of nearly 16%, it surely hides the perils of concentrated investment in gilts. The fund's standard deviation of returns is the highest among bond funds at 2.95 per cent in the last one year.
Or, take the case of Zurich India High Interest. Of late, the fund's gilt exposure has been around 40%, after touching a high of 54% in February this year. While the fund's six-month return is a whopping 8.2% amidst fall of interest rates, it runs the risk of sharp losses in case interest rates harden. Ditto is the case with Kotak Mahindra Mutual Fund's K-Bond (Deposit), which has also been bullish on treasury bonds with investments touching a high of 44.39% in February this year. Since the fund is targeted at retail investors, (the AMC has a different option for big-ticket investors) it needs to cut its aggressive stance since small investors primarily invest in bond funds for steady returns with little risk.
While it may be easy to sell government bonds and reduce exposure in times of volatility, the moot point is that it is not possible to predict when the tide will turn. For instance, most fund managers were left stranded with their gilt investments when interest rates were hiked in July last year. Needless to say, they suffered heavy losses with debt funds losing an average 0.25% in July 2000 alone.
Bond funds, especially the large ones cannot do without gilts in their portfolio, given the high safety and liquidity. Gilts also provide the needed maneuverability -- to actively manage the portfolio duration. But getting overboard with gilts cannot be justified, as it can give a blow to an unassuming bond fund investor. This conservative set of investors will never accept the downside in case it happens. And it can, if interest rates rise without a notice, and there has been precedence as mentioned above. These funds could also be wild with their day to day movements. The onus also lies on the investor, who must check the gilt exposure of their bond fund, as too much of a good thing can be injurious!