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Wednesday, August 17, 2011

A good time to feel ‘Gilt’y – a guest post

The stock market is in a strong bear grip. Even blue-chip stocks are feeling the heat and sliding down at the first hint of trouble. Mid-cap and small-cap stocks have been hit hard.

What can small investors do to protect their capital and get decent returns? In this month’s guest post, Nishit suggests that investors take a look at Gilt funds.

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Last month, the RBI hiked interest rates for the 11th time since March 2010. The Repo Rate is now 8%. When will the RBI signal a pause?

The Repo rate is the rate at which the RBI provides short-term loans to banks. At 8%, it is about 1% below the peak which it achieved three years back. The hike in interest rates by about 3.25% has put pressure on interest rate sensitive sectors like Banks, Automobiles and Real Estate.

It’s a classical economist’s dilemma. If you hike interest rates you lower inflation but sacrifice growth. So, do you want high GDP figures or lower inflation? There is no correct answer. It has to be a mix of both.

The IIP numbers are high and so are the inflation figures. The latest Inflation number was a bit lower than the previous month, but continues to be high. Expect one more round of rate hike in September. The 1 year T-Bill is already quoting at 8.47%.

How do we play this rate hike in our favour? It is time to buy some Government Security (Gilt) funds. This is a time to very easily lock in about 20-25% returns over the next 12-18 months. This is based on the following factors: a) The government will eventually end the rate hike cycle starting with a period of pause and then a gradual reduction in interest rates; b) The 10 year bond yield will drop by about 200-300 basis points (2-3%) over a period of time.

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Government Securities are freely traded in the Debt Market. A 10 year G-Sec having a face value of Rs 100 gives a yield of about 9%. After, say 12 months, the yield goes to 6%. The traded price of each bond goes up from Rs 100 to Rs 150, an increase of 50%. This is the optimistic best price scenario. Looking at entry and exit it is safe to expect about a 25% gain.

If we visit www.valueresearcholine.com, and do a search for Birla Sunlife Government Securities Fund, its best annual performance was from May 2008 to May 2009 when its yield was almost 26%. If we co-relate with the chart above, in June 2006, the Repo rate was 8% which went up to 9% before being brought down to 4.75% in April 2009. So, a net reduction of 3.25 % in the Repo rate was good enough to give the above returns.

Strategy:

Should we wait for further rate hikes before investing? It is not possible to always time the markets, so allocating about 50% of the investible funds now and rest after the September RBI policy announcement may be a prudent course of action.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

4 comments:

Subhankar said...

Query from Karthik:

Nice guest post! I'd like to understand how repo rates, and the T-bills trade price and the T-bills returns interact with each other. I remember stumbling upon an article that nicely explained this when I started learning about investing, but am not able to find it now. Do you have any link?

Nishit Vadhavkar said...

When repo rates increase, T- Bills increase. Repo is rates at which Banks borrow from the RBI.
Now, if we hold till Maturity then you get interest as per value promised. Now, if Repo Rates increase, then bond prices fall of T Bills thus increasing the yield.
Note: We make money on bond prices rising, so if we are not going to Hold Till Maturity we will lose money.

Bikash Bhalotia said...

Just a small question - How bond price would increase by 50%, if the yield were to decline by 3%? I believe that the appreciation in that case would be a good but lot less ~20%. Another question - How realistic is it to assume a drop of 300bps when inflation continues to rule high and strong?
Humbly,
Bikash

Nishit Vadhavkar said...

3 quick answers.
1.The graph shows past history of dip in Interest Rates.
2.I have shown the calculation, how it works, you can co-relate with the graph
3. Check out past returns at Valueresearchonline.com