{"id":19093,"date":"2020-07-08T13:01:26","date_gmt":"2020-07-08T07:31:26","guid":{"rendered":"https:\/\/www.fundsindia.com\/blog\/?p=19093"},"modified":"2020-07-15T15:36:24","modified_gmt":"2020-07-15T10:06:24","slug":"6-different-view-points-to-consider-before-you-buy-gilt-funds","status":"publish","type":"post","link":"https:\/\/www.fundsindia.com\/blog\/mf-research\/6-different-view-points-to-consider-before-you-buy-gilt-funds\/19093","title":{"rendered":"6 Eccentric People Who Can Change The Way You Approach Gilt Funds"},"content":{"rendered":"

In recent times, we have been receiving a lot of queries on –<\/p>\n

Is it the right time to invest in Gilt funds?<\/b><\/p>\n

Instead of straight away revealing our views, we wanted to use this as an opportunity to introduce you to our thinking process.<\/p>\n

We have realized that some of the best decisions come from changing the way we think about problems, and examining them from different viewpoints.<\/p>\n

So, instead of approaching this question from a single point of view, we will be approaching this via 6 different vantage points.<\/p>\n

Let us check what our 6 different friends have to tell us..<\/p>\n

QUICK GUN MURUGAN:<\/b> Looks at problems using intuition, gut reaction, and emotion!<\/b><\/span><\/h4>\n\"\"<\/a>\n

His mind voice goes like this..<\/p>\n

Credit Risk Funds are going through several issues – defaults, downgrades, redemption pressure, illiquidity, concentration risk etc.<\/p>\n

A lot of credit risk funds have given poor returns in the last 1-2 years!<\/b><\/p>\n

Franklin Templeton Mutual Fund recently has closed 6 of its credit risk oriented funds!<\/b><\/p>\n

OOPS! I guess it is better to stay away from credit risk and stick to safe high credit quality debt funds.<\/p>\n

Umm..So what can possibly be the safest debt option out there?<\/p>\n

Debt funds which lend to the Government of India!<\/b><\/p>\n

It is reasonable to expect that the Government of India most likely will not default on their payments.<\/p>\n

So how about Gilt Funds which lend only to the Government?<\/p>\n

Let me check their returns..<\/p>\n\"\"<\/a>\n

Note: We have considered the largest 5 funds in the category with more than 15 years of track record.<\/i><\/p>\n

WOW! Great Safety & Great Returns – Let me buy Gilt Funds!<\/b><\/p>\n

This is one perspective which most of us would have at this point in time. But let us also explore other perspectives before we decide.<\/p>\n

CURIOUS KID: <\/b>Damn curious and asks a lot of questions<\/b><\/span><\/h4>\n

If the last 1 year, average returns of gilt funds are 13.4%. So I should have invested 1 year back.<\/p>\n

But why didn\u2019t I invest then?<\/b><\/p>\n

What was the fund\u2019s underlying interest rate (for the purists, read it as YTM) a year back?<\/p>\n\"\"<\/a>\n

Umm..Something is not adding up..<\/p>\n

The government had borrowed money from this fund at an average of 7.2%. So logically we were supposed to make 7.2% minus the expense ratio (1.1%) at 6.1%. How come we ended up with 13.4%.\u00a0<\/b><\/p>\n

Where in the world did that extra 7.3% (13.4% minus 6.1%) return come from?\u00a0<\/b><\/p>\n\"\"<\/a>\n

Anyway, What is the underlying interest rate now?<\/b><\/p>\n\"\"<\/a>\n

So should I expect 4.9% returns going forward? Or like last year will I get a similar extra return?<\/p>\n

What if it becomes lower than 4.9%?<\/p>\n

Someone care to explain??<\/b><\/p>\n

MR SPOCK – inspired from the super rational Star Trek character<\/b><\/span><\/h4>\n\"\"<\/a>\n

Past returns are already over. I am only worried about how much I will make going forward.<\/p>\n

What will be my future returns?<\/b><\/p>\n

1 Year Returns = Net YTM + NAV changes due interest rate movement*<\/b><\/p>\n

NAV changes due interest rate movement = (-1)<\/em> (Modified Duration) * (Change in yields)<\/p>\n

Looking at past returns (13.4% in the last 1 year), we might subconsciously get our expectations anchored to the same returns. However we must remember that, out of the 13.4% returns, roughly 6.1% returns came from the Net YTM (6.1%). The extra 7.3% were predominantly due to gains from fall in yields (~120 bps or 1.2%).<\/p>\n\"\"<\/a>\n

So using the same logic, the current Net YTM is ~4.9%. Whether you make returns higher or lower than this will depend on yield movement. If yields go down, you will make higher returns and vice versa.<\/p>\n

Let us look at what can be the possible return outcomes for different moves in interest rates.<\/p>\n\"\"<\/a>\n

*These are approximate return estimates given for illustrative purposes. The actual returns may vary based on the intermittent changes in the portfolio<\/i><\/p>\n

HISTORY PROFESSOR: <\/b>Ardent believer of the Mark Twain quote ‘History doesn’t repeat itself but it often rhymes’<\/span> <\/b><\/h4>\n\"\"<\/a>\n

1. Do past returns predict future returns in Gilt funds?<\/span><\/strong><\/p>\n\"\"<\/a>\n

Note: For Short term funds we have considered the largest 5 short term funds with 15 year track record – DSP Short Term Fund – Growth, ICICI Prudential Short Term Fund – Growth, IDFC Bond Fund – Short Term Plan – Growth, Kotak Bond Short Term Fund – Growth, Nippon India Short Term Fund – Growth<\/i><\/p>\n

As seen above unlike the plain vanilla short term category (black line), gilt funds have had a wider range of return outcomes. Usually above average returns are followed by below average returns which is mostly a reflection of interest rate movements.<\/p>\n

Takeaway 1: Past returns have been a poor predictor of future returns in gilt funds.<\/span><\/strong><\/p>\n

 <\/p>\n

2. Are Gilt funds more volatile?<\/span><\/strong><\/p>\n

Let us check the Volatility of the category vs Short term funds.<\/p>\n\"\"<\/a>\n\"\"<\/a>\n\"\"<\/a>\n\"\"<\/a>\n\"\"<\/a>\n

As seen above visually, Gilt funds have far higher volatility.<\/p>\n\"\"<\/a>\n

Even the maximum drawdown has been much higher for Gilt funds!<\/p>\n\"\"<\/a>\n

Also the occurrence of negative returns has been much higher across time frames.<\/p>\n

Takeaway 2: Gilt funds have far higher volatility and intermittent declines compared to the plain vanilla short term funds. <\/span>
\n<\/span><\/strong><\/p>\n

Investors for putting up with this higher volatility should ideally be compensated by higher long term returns. Let us check if this is true?<\/p>\n

 <\/p>\n

3. Do Gilt funds compensate for their volatility with higher long term returns?\u00a0<\/span><\/strong><\/p>\n\"\"<\/a>\n

As seen above, over long periods the returns from Gilt funds and Short Term funds is more or less similar.<\/p>\n\"\"<\/a>\n

As seen above for the last 15 year period,<\/p>\n