Retail investors should be wary of gilt funds

There is an underlying assumption that bonds of highly rated corporates or even the government are considered safe. This is because when we tend to look at risk, we generally discount equity into that argument.

What we forget to take note is that every investment has an ingrained risk and that could happen to even the debt-oriented investments whether secured or unsecured.

Debt basically is a loan raised by a corporate, government or institution to fund or finance a particular project or expansion and sometimes even to reduce an existing loan with a higher cost.

There is an underwriting process taken by lender when providing a loan or in cases where the debt is raised by the institutional body (within the purview of the prevailing regulations) various norms are followed and the risk here has to be assessed by the lender i.e. investor.

The important factors generally considered is the purpose of the capital being raised, how would it impact the existing cash flows of the organisation, how would it help better the situation of the borrow after the capital is raised and the debt servicing capacity of the borrower.

Debt servicing is nothing but the capacity of the borrower to repay the principal along with the agreed periodic interest.

This depends upon the overall asset-liability structure and the cashflows of the borrower both current and future (forecasted) asides to the sector outlook and the general business environment. The critical aspect however remains in the solvency of the borrower.

In debt mutual funds (MF) predominantly the securities comprise of these debt instruments which are of course vary in their duration (tenure of holding) and yield (return if held till maturity) though, the fund managers have every right to trade depending on their liquidity requirements and assessment of the risk, etc.

These debt instruments could have been bought by the fund either in the primary market or secondary market and sometimes the fund houses themselves act as underwriters to raise capital for a corporate.

The Fixed Maturity Plans, FMP, as they are popularly known as would participate in this kind of capital raising.

The fund picks up instruments that form part of their portfolio and the allocation again depends upon the fund liquidity requirements, fund objective and the risk profile of each of the said funds.

The inverse relationship between bond price and interest rate is first and foremost factor for the volatility in any debt fund.

The bond prices tend to fall down during an increasing interest rate scenario as the demand for the existing bond with lower interest rate is slackened while investors typically pursuing better returns would tend to opt for instruments with higher interest rates and vice versa.

Most of us consider, a government security as stable and highly secure for the sovereign guarantee it holds. But, in reality these bonds or securities are also traded and are highly volatile.

The price fluctuations depend upon the demand-supply dynamics compounded by the government decisions, macro-economic policy and factors that are linked to economy, interest rates and politics. However, Government bonds have lower default risk when compared to corporate and other institutional bonds.

So, when Reserve Bank of India (RBI) recently cut interest rates, the yields on the longer duration bonds mostly Government securities (G-Sec) and other government bonds have gone up.

The interest rate policy of India's central bank has not been only one-way direction in the last three years and wavered between hawkish to dovish.

Now, the unanimous decision of the Monetary Policy Committee (MPC) to turn accommodative does not likely mean it's going to be a continued process of rate cuts for the near future.

The RBI and the MPC make decisions on the available data and their forecast of the near-term future based on the global and domestic environment.

Investors looking for higher returns out of debt funds should not hurry into exposing themselves into Gilt funds (debt funds with predominantly govt securities) simply because the past performance of last year is upwards of 10 per cent as they are subjected to high volatility.

Moreover, dealing with gilt funds also requires tactical knack of entry and exit into these funds.

Retail investors should be wary of these funds and investors with moderate to high risk appetite could have an exposure that is in-line with their timelines.

(The author is co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)