Dynamic bond funds a better option than gilt

In the former, funds change the maturity and asset mix depending on the market situation, giving it stability. The latter is too volatile

The recent spike in returns of gilt funds has attracted investors’ attention. With interest rates expected to gradually go down in the future, many are contemplating whether investing in gilt can reap rich rewards.

If you look at a one-year period, medium- and long-term gilt funds have average returns of 10.57 per cent. The best performing one, BNP Paribas Government Securities Fund, has 12.84 per cent, according to Value Research. Edelweiss Gilt Fund has the lowest returns at 7.53 per cent. A majority of them have 10 per cent returns.

However, according to analysts and financial planners, gilt funds are not an ideal choice for retail investors if they have an investment horizon of two years. Mutual fund platforms such as Fundsupermart, FundsIndia, and financial planners suggest either dynamic bond funds or income accrual schemes. “As medium- and long-term gilt funds have a high portfolio maturity, they tend to be extremely volatile,” says Suresh Sadagopan, a certified financial planner.

The bulk of gilt fund returns come only during the rate cut, after which they are normalised. These funds are also more sensitive to currency movement; the government’s borrowing programme; and supply and demand. For example, in the past month, the returns from gilt funds are negative (category average is -0.17 per cent). “As these funds are fully invested into G-Secs of a longer tenure, the interest rate movement becomes very crucial for this category. Hence, these funds are subject to huge volatility that retail investors would generally not be comfortable with,” says Renu Pothen, research head at Fundsupermart.com.

Lakshmi Iyer, chief investment officer (debt) and head of products at Kotak Mahindra AMC, says that while bond funds as well as gilt might work for retail investors in the long-term, the latter carries interest rate risk and requires investor to be experienced to stomach it. Bond funds don’t take credit risk to the same extent.

Most analysts feel that to benefit from gilt funds, an investor needs to time the entry and exit. This requires taking a call on interest rates movements and a view on what the Reserve Bank of India will do in its credit policy. If it goes wrong, returns can get impacted. Sadagopan says that at present, there’s a general view that interest rates are gradually coming down and it’s been happening. In the past, in similar situations, there were periods when interest rates firmed up or spiked, pushing gilt fund returns into the negative territory.

Investors are, therefore, better off investing in dynamic bond funds or interest accrual schemes depending on their horizon. These funds keep a mix of corporate bonds and government securities (G-Secs). These funds also change the maturity of the portfolio and the investment mix depending on the scenario giving stable returns over the long term. “Depending on the fund manager’s view on interest rates, dynamic bond funds have the flexibility to move across different tenures and instruments and, hence, they would be less volatile than pure gilt funds,” says Pothen. In the current scenarios, for example, many dynamic bond funds have raised the G-Secs exposure in the portfolio.

This is also apparent if you look at the returns over the long-term of best-rated funds by Value Research. Some of the five-star gilt funds in their worst performance have had negative returns in double digit for one-year period, whereas five-star rated dynamic bond funds never went negative in one year period.

For retail investors, timing gilt fund is difficult, say experts. Also, it’s not tax-efficient to move in and out of debt schemes for superior returns of few basis points.