A re-look at Gilt funds – a guest post

After a decent rally during 2012, backed by strong FII inflows in 2012, the stock market touched 2 year highs. A correction has ensued since then. Slow down in economic growth has forced the RBI’s hand in lowering repo and reverse repo rates, though inflation remains high.

In this month’s guest post, Nishit argues in favour of an investment in Gilt funds – since repo and reverse repo rates have started on their way down.

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We had last reviewed Gilt funds in the month of August ‘11. A lot has changed since then. Let us take a look at where we stand now.

The 10 year bond was trading at 8.2% approx. In a period of 6 months, the rate has come down to 7.9% approx. A period of 6 moths and a rate drop of 0.3% - how does it translate into real returns for an investor?

The Birla Sun Life Government Securities fund, which is a blue chip fund with a 5 star rating from Valueresearcholine.com, has provided an absolute return of 6.61%. When annualized, it becomes 13.22%.

In the next 6 months, Interest Rates should fall by about another 0.5%. Typically in this Interest Rate cycle the peak and the bottom is usually 300 basis points minimum. The peak was about 9%, so the rates should bottom around 6 to 6.5% in the next 2 years.

Now is the time to invest in Government Securities funds, as the Interest rate cycle has clearly started its way down.

Government Securities are the highest rated securities. A default on them is almost impossible, as it would amount to a sovereign default of the Indian state.

If we look at other funds like Income funds, the rate of return has already declined. The trick to make profits from Gilt funds is to ride out the bottoming out of Interest Rate cycle and then move the money back to equity. Typically when the Interest Rate cycle bottoms, it is time to move back into equity.

This happened during October 2008 to March 2009. It happens because rate cuts stimulate the economy - which also means the economy is doing pretty badly. Stock markets are usually 6 months ahead of the economy. When the rate cuts stop and the yield bottoms out, it is also time to invest in equity.

The chart below illustrates how the cycle works. One can compare it with the equity cycle. The rate cuts bottomed out in Dec 2008 and equity markets bottomed in March 2009.

The idea of investing is to safely make a compounded return of around 15-16% every year. When the equity markets are headed downwards, it is time to make money in Gilts and when Gilts are headed down, it is time to make money in Equity Markets.

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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.)