Investing In Gilt Funds To Become Trickier Now. Caution!

May 28, 2016

Monetary policy stance and economic indicators, decide in which direction the Indian debt market would head. So far, the Indian debt markets has had a reasonably easy run for at least around 16-18 months.

As the inflation was on the downward spiral and there was a great discipline in the monetary policy actions, optimism captivated debt market investors. Government Securities (G-sec), market also known as the sovereign bonds, remained investors' favourite. However, the high tide of optimism seems to be receding silently.

Since January 2015, the Reserve Bank of India (RBI) has lowered policy rates by 150 bps thus far. The Government too has displayed its commitment to walk tight on the path of fiscal consolidation and easing the supply of essentials that otherwise cause inflation. The resilience exhibited by the India Rupee (INR) against the U.S. dollar (US$) is also a positive. Under the Dr. Raghuram Rajan, RBI not only has adopted newer policy approaches but also addressed some chronic systemic problems too. As a result, investors have found more solace in Indian sovereign debt.

However, there's a debate...

The debate on whether Dr. Raghuram Rajan should be given an extension in term as the Governor of RBI. Taking fresh potshots at one of the most respected central bank governors across the world, BJP MP Dr Subramanian Swamy, wrote a letter to the Prime Minister requesting immediate termination of Dr Rajan's services. Vindicating his point, Dr. Swamy wrote a letter to Prime Minister, Mr Narendra Modi expressing, "The reason why I recommend this is that I am shocked by the wilful and apparently deliberate attempt by Dr. Rajan to wreck the Indian economy".

Now, this hasn't been the first instance of salvo at Dr. Rajan, whose term ends in September this year. Dr. Swamy, who has taught economics at the Harvard, has written vehemently against Dr. Rajan. "The Reserve Bank of India (RBI) Governor, Raghuram Rajan, has single-handedly brought a huge slowdown to the Indian manufacturing sector and exports. As a doctor, he has believed that the best way to bring down the temperature of a patient (i.e., inflation) is to kill him (investment starvation)." he has expressed.

Debt markets seem to be in disagreement with Dr. Swamy's comments

It now remains to be seen if Dr. Swamy succeeds in persuading the Government to disallow an extension of term to Dr. Rajan.

However, investors seem to be worried about this uncertainty. Until now, debt markets have responded well to almost all decisions that the present RBI governor has taken. Going purely by the fund flows in the sovereign debt (gilt) investors are becoming increasingly cautious at a time when Dr. Rajan nears the end of his term, and macroeconomic developments become trickier.

Gilts Funds: Are they losing steam?

Over last three months, investors have pulled out over Rs 2,000 crore from gilt funds. Gilt funds predominantly invest in Government securities and can be further classified based on their investment duration, as short term gilt funds and the long-term gilt funds.

Is this a Dr. Rajan effect?

Bond markets do not like any ambiguity on the interest rates. Now that, they are becoming acquainted with Dr. Rajan's style, the aforesaid debate is causing a stir.

In last two decades, India has seen four RBI Governors-Dr C.Rangarajan, Bimal Jalan, Dr Y V. Reddy and Dr D. Subbarao. Except for Y.V. Reddy, all other governors have served a five-year term in a format wherein the first three year's term was extended by another two years. However, Y.V. Reddy got the full five-year term under Mr. Vajpayee lead NDA Government.

Thus taking cognizance of the above, if north block denies another term to Dr. Rajan, he would be the first one, atleast in two decades to serve only for three years as Governor of RBI. Moreover, the timing of Dr. Rajan leaving RBI would be wrong. Under him, RBI has set a target of achieving 5% retail inflation by March 2017. If a steadfast governor like him leaves and a one working under the influence of the Government replaces, there are chances that the currently established monetary policy structure and the framework may be disturbed. And unfortunately, the Indian debt market is suspect that such a phase might be in the offing.

Moreover, looking at the current inflationary trends, curtailing inflation under 5% is not an easy task. For April 2016, retail inflation shot up to 5.39% vis-a-vis 4.87% recorded a year ago. Now markets would tracking Indian Meteorological Department's forecast of an above-normal southwest monsoon closely.

What should be your approach while investing in gilt funds?

As gilt funds do not have any default risk, they stay in high demand when asset quality of the portfolios of income funds dips. Moreover, predictable policy environment reduces the interest rate risk to an extent.

The performance of Gilt Funds...

Category Average	Returns Absolute (%)		CAGR Returns (%)
	6 Months	1 Year	2 Years	3 Years	5 Years
Long Term Gilt Funds	3.6	8.2	11.2	7.2	8.9
Short Term Gilt Funds	3.8	8.5	10.0	8.1	8.7
I-BEX (I-Sec Sovereign Bond Index)	4.8	9.9	12.7	7.9	9.8
I-BEX (I-Sec Sovereign Bond Index)	4.8	9.9	12.7	7.9	9.8
I-Sec Composite Gilt Index	4.7	9.8	11.7	8.0	9.6

Data as on May 17, 2016
(Source: PersonalFN Research)

Let's not forget a basic principle: bond prices and the interest rates share inverse co-relation. As per RBI the reduction interest rates of SSS (announced in March this calendar year), substantial refinements in the liquidity management framework and the introduction of the marginal cost of funds based lending rate (MCLR) is expected to improve transmission and magnify the effects of the current policy rate cut. Hence, it is stated that the stance of the monetary policy will remain accommodative while the Reserve Bank will continue to watch macroeconomic and financial developments in the months ahead with a view to responding with further policy action as space opens up. But this guidance, issued in the first bi-monthly monetary policy statement for 2016-17 would need to be watched carefully, given the uncertainty over an extended term to Dr. Rajan. A lot will depend on how seamless the transition would be if Dr. Rajan has to leave indeed. It would be a litmus test of all the the systems adopted by RBI in the recent past and bring the spotlights on the independence of RBI.

The second bi-monthly monetary policy statement for 2016-17 is scheduled on June 7, 2016. The Reserve Bank would prefer to watch the distribution of rainfall across the before it turns further accommodative in its monetary policy stance. Moreover, hike in wages, pension of Government employees later this year, plus the service tax rate is likely to upward pressure on prices although some relief is expected from forecasted above-normal southwest monsoon. In our view, drought stricken India badly awaits dark clouds, but not on the horizon of RBI.

Given the above, we think pressure may build at the longer end of the maturity curve. Besides, most of the rally has already been captured at the longer end, although some steam remains on the expectation of accommodative monetary policy stance by RBI. Thus don't go overboard while investing at the longer end, especially in vide long-term gilt funds. We suggest, consider dynamic bond (as they are enabled by their investment mandate to take positions across maturity profile of debt papers) while taking exposure at the longer end, provided you have an investment horizon of at least 3 years.

In case you have a time horizon of less than a year, stay away from funds with longer maturities. If you have a short-term investment horizon of 3 to 6 months, consider investing in ultra-short term funds (also known as liquid plus funds). And if you have an extreme short-term time horizon (of less than 3 months) you would be better-off investing in liquid funds.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

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