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GILT Funds – A mixed bag of news

Apr 4, 2000

The cut in the bank rate (BR) and cash reserve ratio (CRR) could not have come at a better time for the government securities funds, which have under performed most other mutual fund schemes. However, will the boom in government securities last? The government has been consistently trying to talk down interest rates with a view to reduce borrowing costs for the manufacturing sector (which has yet to see a significant pick up in investment activity). First it reduced the minimum return stipulated under the provident fund schemes and then it withdrew the interest tax. However, finally it was the Reserve Bank of India’s (RBI) decision to cut the CRR and the BR that resulted in banks reducing interest rates.

All along this period GILT (government securities) funds witnessed volatility in GILT prices as expectations of rate cuts ebbed and flowed. By the time, the rate cuts were announced, the discounting was all but complete.

Why is a cut in the interest rates good news for GILT funds? Well, when interest rates are reduced, so are the expectations of investors i.e. they are willing to settle for a lower yield (implying higher bond prices) as opportunity costs are lower. Look at it from the technical point of view – Suppose the 10 year government bond (risk free) is yielding 8%, and interest rates are 12%. When the rates reduce to say 11%, the 10 year bond will become relatively more attractive thus driving investor interest. In such a scenario bond prices would move up and the implied yield would decline so that it becomes relatively neutral.

Therefore ideally speaking, the GILT funds would benefit as higher GILT prices would imply a higher net asset value (NAV). However, in realty, the situation may not turn out like this.

And this is because of the Central Government's huge fiscal deficit of Rs 1,100 bn that needs to be financed from borrowed funds. Such a large deficit implies that the supply of government paper, in relation to demand for the same, is likely to be high (thus driving down bond prices). Net result – probably higher yields (lower bond prices).

The performance of the GILT funds is directly related to the government's borrowing program and given the existing fiscal position of the centre, the prospects are not too rosy. But then again, investing in a risk free security has its benefits – an investor on the NASDAQ would know that.

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