Make sense of rising interest rates and falling bond prices to ensure that your gilt bets hit the bull's eye
HERE'S a tricky question: Do all investors gain from rising interest rates? Well, if you are the kind who invests only in fixed deposits, rising interest rates work well. But that is not the case with some other forms of investments, particularly gilt funds.
Gilt funds are schemes that invest in government securities, which are also known as gilts. Government securities are financial securities issued by the Reserve Bank of India (RBI) to help the government finance its fiscal deficit.
Since government securities have a minimum investment limit of 5 crore, most investors cannot invest directly in them. So, gilt funds are more or less the only way through which retail investors can invest in government securities as the minimum investment limit in a gilt fund is 5,000.
How Do Gilt Funds Earn Returns?
Gilt funds invest in government securities which pay interest every six months. Of course, that's one way gilt funds earn a return. The other component is the increase in value of the government securities these funds invest in. The market price of government securities and interest rates move in opposite direct directions. So, when interest rates are on their way down, the price of government securities goes up and vice versa.
But why does this happen? When interest rates are on their way down, the newer government securities issued by RBI offer a lower interest rate. This pushes up the demand for the government securities already there in the market which offer a higher interest rate. This is what increases the price of these securities, which translates into more returns for the gilt funds which hold these securities.
Why Should You Invest In Gilt Funds?
Inflation has been the big reason behind RBI raising interest rates in the recent past. The central bank has hiked the repo rate (the rate at which banks borrow short-term money from RBI) by 125 basis points (one basis point is one hundredth of a percentage) this financial year (i.e. April 1, 2010). This, in turn, means that gilt funds haven't been doing well lately, because higher interest rates push down the price of government securities and that, in turn, means lower or negative returns for gilt funds.
But the good thing is that inflation is clearly on its way down. This, experts feel, may prompt RBI to halt rate hikes. The country has had a good monsoon and bumper crops will ensure that food inflation will gradually come down. Further, most of the government borrowing programme will be over by December 2010, which will mean that there would be greater money available in the market, leading to lower interest rates.
Inflation coming down and most of the borrowing programme getting over by December 2010 along with RBI is nearing the end of rate hike spree.
In the recent past, several government-owned companies have sold new shares to the public. This has helped the government improve its fiscal deficit, which is essentially the difference between what the government earns and what it spends. It borrows to fill in the gap. The government was also helped by the sale of 3G spectrum to telecom companies and sale of broadband wireless access (BWA) services which together helped it raise 1.06 lakh crore.
With these proceeds firmly in its kitty, the Government of India, the biggest borrower, is expected to borrow less. When the demand for money goes down and so does the price of money or what is commonly understood as interest rates.
As explained earlier, the prospect of lower interest rates would mean higher prices for government securities and, thus, greater returns on gilt funds. It makes sense to invest in gilt funds now with a horizon of at least 6 months to 12 months, as we can see food inflation coming off the high levels with good monsoon and a good rabi output. This should push inflation to 6% by March 11 and will help gilt funds.
Which Funds Should You Go For?
Investors should look at funds with a track record of more than five years (see table). This will ensure that you will hand over your money to a fund which has seen the market cycle well. Also, since the minimum investment in government securities is 5 crore, it makes sense to go with a fund with assets in excess of 50 crore. It is better to avoid small funds as the fund manager will find it difficult to manoeuver his investments. You can get this information from the fund fact sheet that is readily available on the website of the mutual fund.
What Are The Risks?
The biggest risk is of a sudden upswing in interest rates. Quantitative easing (printing of dollars) in the US can push up the prices of commodities and further fuel inflation. Of course, not all are bullish on gilt funds. The government is not able to control expenditure which is inflationary in nature. And that may mean further interest rate hikes from the RBI and a tough time for gilt funds.
