The Reserve Bank of India’s sudden change in stance from accommodative to neutral in its February policy this year, brought the ongoing party in gilt funds to an abrupt halt. Highlighting possible upside risks to its inflation target in the recent April policy, the central bank has only reinforced the near zero possibility of further rate cuts.
After delivering tidy returns of 16-17 per cent in 2016, gilt funds have started to lose sheen over the past two to three months. In 2017, so far, the top-performing funds have delivered just 1-2 per cent returns. So is the party over for gilt funds?
Looking back
The RBI cut its key policy repo rate by a whole 175 basis points from the beginning of 2015 till the end of 2016. The yield on 10-year government securities also dropped from 8.06 per cent to 6.21 per cent during this period. This led to gilt funds raking in tidy gains for investors.
Gilt funds mainly invest in government securities. In a falling interest rate scenario, the attractiveness of older bonds increases and hence their prices move up. Hence, interest rate and bond prices have an inverse relationship.
Between end of March 2014 and March 2015, when the 10-year G-sec dropped from 8.8 per cent to 7.7 per cent, long-term gilt funds returned around 17 per cent. During 2016, the yield on G-Secs fell by another 130-odd basis points. Gilt funds continued to deliver healthy double-digit returns for investors.
However, since February this year, the yield on G-Secs has started to move up, now hovering close to 6.8 per cent levels. This sudden increase in yields has dampened returns from gilt funds.
Top performers; laggards
Over the last three months, the performance across long-term gilt funds has varied considerably, leading to wide divergence in their one-year performance. Top-performing funds such as UTI Gilt Adv-LTP(G), SBI Magnum Gilt-LTP-Reg(G), Invesco India Gilt Fund(G), IDFC G Sec-PF-Reg(G) and Canara Robeco Gilt PGS-Reg(G) returned 13-16 per cent.
The funds that didn’t fare so well, Sundaram Gilt Fund(G), Franklin India G-Sec-Comp(G), Birla SL G-Sec-LTP(G), Baroda Pioneer Gilt Fund(G) and Axis Constant Maturity 10-Year Fund(G), returned between 8.8 per cent and 9.6 per cent.
Gilt funds that called the right shots over the past three months have outperformed. The two top performers, for instance, cut their maturity, notably between November 2016 and March 2017, ahead of the sharp rise in rates in February this year. Remember, longer maturity bonds are more sensitive to interest rates and hence, in a rising rate scenario, fund managers cut the duration to cap losses. Canara Robeco Gilt PGS-Reg(G) (from 17.7 to 9.1 years) and JM G-Sec Fund - Regular Plan (from 21 to 8.6 years) too followed a similar strategy.
However, for some of the laggards, sticking with a longer maturity period led to under-performance.
The assets under management (AUM) for gilt funds rose from ₹16,306 crore to ₹18,574 crore between March 2016 and November 2016 before dropping to ₹14,875 crore at the end of March 2017.
What next?
Trends in domestic inflation and rate actions by the US Fed will determine the direction of interest rates in our economy in the coming months. For now, the market appears to have factored in no further rate cuts by the RBI.
While the US Fed raised rates in March recently, it stuck with its earlier projection of two more rate hikes for the calender year. This too has been priced in by bond markets in India. However if the Fed decides to hike rates more aggressively, yields in our market too could follow suit.
In short, for gilt fund investors, the party is clearly over and the upside from here on is most likely to be limited.