High interest rate management yields better returns

In the past year (ended December 2012), the fund's assets under management grew 90 per cent to Rs 502 crore

Launched in 1998, Kotak Gilt - Investment has been ranked CRISIL Fund Rank 2 (represents good performance in the peer group) in the long-term gilt category under the CRISIL Mutual Fund Ranking for the quarter ended December 2012. This fund, which seeks to generate returns by investing in securities issued by central and/or state governments, has been ranked in the top 30 percentile (CRISIL Fund Rank 1 and CRISIL Fund Rank 2) since September 2009.

In the past year (ended December 2012), the fund's assets under management (AUM) grew 90 per cent to Rs 502 crore. At the same time, the category AUM grew 43 per cent to Rs 3,501 crore. The AUM picked up on expectations of interest rate cuts by the Reserve Bank of India (RBI). Interest rates and bond prices (or fund net asset values, or NAVs) move in opposite directions.

When interest rates fall, newer bonds are issued in the market at lower coupon rates; thus, the demand for older bonds in the market - with higher coupon rates - goes up. Higher demand leads to increase in the prices of government bonds, which ultimately results in higher NAVs (returns) from gilt funds. Further, bonds with a longer maturity benefit more than those with a shorter maturity in a falling interest rate scenario and vice versa.

Risk-return attributes
The fund has outperformed its benchmark (I-Sec Composite Index) and peer group across various time frames, viz, six months, one, two, three, five and ten-year time frames.

Over the one-year period ended March 5, 2013, the fund returned 12.77 per cent against 11.02 per cent by the benchmark and 10.66 per cent by the category. Over the longer term of 10 years, the fund has returned 7.82 per cent (annualised gains) compared to 7.29 per cent and 6.70 per cent given by the benchmark and the category, respectively.

The fund has given superior returns for the risk taken compared to peers. Sharpe ratio, a measure of risk adjusted return, helps the investor to understand how much return is generated in exchange for the risk taken on the investment. The fund had a Sharpe ratio (higher the better) of 1.71 against the category's 1.33 over a three-year time frame.

Active management of interest rate risk

The fund has dynamically managed interest rate risk. This can be seen from the inverse movement of average maturity of the fund with the 10-year government security (G-sec) yield. The fund has increased the average maturity of the portfolio when interest rates were expected to fall and vice versa.

The fund increased the average maturity from 2.97 years in March 2012 to 12.33 years in January 2013 in anticipation of an interest rate cut by the central bank. In January 2013, RBI cut the repo rate by 25 basis points (bps) or 0.25 per cent. During this period, the month end 10-year G-sec moved down from 8.75 per cent (March 2012) to 8.07 per cent (January 2013).

When the month end 10-year G-sec yield increased from 8.14 per cent in March 2011 to 8.59 per cent in May 2011, the fund reduced its maturity to 0.57 years (April 2011) from 7.91 years (February 2011). Yields increased on account of the 50 bps (0.50 per cent) hike in repo rate by the central bank in May 2011.

Portfolio analysis
While the fund has predominantly invested in central government securities, it has also taken exposure to state development loans (SDLs) when their average spreads over central government securities were high.

For instance, in May 2012, the fund took 27 per cent exposure to 10-year SDL paper, with a yield of 9.12 per cent. The 10-year G-sec yield was at 8.38 per cent around that time (spread of 74 bps). A similar trend was observed in September 2012, when the fund took exposure to an SDL paper with 8.93 per cent yield, when the 10-year G-sec yield was around 8.15 per cent (spread of 78 bps).

Over the past three years, the fund had 70 per cent exposure to central and state government papers, while the rest was invested in cash equivalents.

CRISIL Research