Investors should hold gilt funds for at least two years

Debt instruments carry two main types of risks-credit risk and interest rate risk. Credit risk is when issuer of the debt instrument is unable to pay interest or principal on the due date. Since government has zero-risk of defaulting,credit quality of gilt funds is of the highest order. Interest rate risk arises since market price of a debt security varies with fluctuating interest rates.

Price falls when interest rates rise while it increases when interest rates fall. So,long-term gilt fund is useful for capital gains in a declining interest rate environment. For example,if you have lent Rs 100 at 7% fixed annual interest for 5 years and suppose after one year,rates fall to 5%,the buyer for your debt security will have to pay a market value much higher than Rs 100. Reason is simple,he will still be receiving fixed annual coupon of Rs 7. However,by paying more than the face value of Rs 100,his effective yield is aligned to prevailing market yield of 5%. For a longer term debt security,the fixed coupon is locked in for a much longer duration; therefore market value of the security will rise even higher. In other words,interest rate sensitivity is greater for a longer duration instrument.

While stocks are wealth builders,debt instruments are wealth preservers. These have two fundamental properties that make them a very important part of any portfolio. First,they provide steady income,sometimes with tax advantages. Second they often,though not always,move in an opposite direction to that of stocks. For example,bond prices typically go up when government reports increased unemployment rate. Difficult economic conditions causing erosion in stock prices are when bonds do well; and this inverse correlation helps in the portfolio chugging along during various stages of the business cycle.

Analysing market performance during the last 5 years,Gilt funds-medium term and long term have returned on an average annualised 4.31% in 2010,-0.12% in the last 2 years,7.08% in the last 3 years and 6.34% in the last 5 years. It is obvious that the majority of returns in the last few years came in the single year 2008. The 2008 return was 21% when the economy was under tremendous pressure,stock market went down from 21,000 to 8,000 and interest rates were being reduced.

My recommendation for a retail investor always is not to employ gilt funds with a trading perspective or for a time horizon of less than two years. He should still wait for the part of the cycle where economy is showing signs of slowing down,stocks are overvalued,and 10-year bond yields are at a high level. At that juncture,portfolio could be rebalanced with taking profits on stocks,moving that money to gilt funds and then keeping an alert watch on 10-year government bond yields.

Summarising,gilt funds are very important part of asset allocation with their inverse correlation to stocks and they could contribute significantly to the yield enhancement of a portfolio. However,these have to be utilised judiciously,for example,short term debt funds will be much better in the current environment where central bank is raising interest rates.

* The writer is founder of http://www.financedoctor.in and author of Winning the Wealth Game