Why are Long Term Gilt Funds Falling?

Many Investors, especially senior citizens, who purchased long term gilts funds (or their cousins, dynamic bond funds) after seeing recent double-digit returns, are puzzled and even worried about why these funds are falling since the last three months. In this post, I discuss the reasons behind this and how to make sense of debt fund NAV movements.

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Take the case of ICICI Long Term Gilt Fund. Suppose I notice that it had given a spectacular 17.98% returns in 2014 and put my money in early 2015, I would have got only a 5.53% return that year.  If I saw the 18.17% return it made in 2016 and put my money in early Jan 2017, the fund would have lost 4.56% (in absolute terms) in the last 3 months.  If I am shocked by this volatility, I have only myself to blame. I looked at returns without understanding the product. And you would be surprised how many people buy what they do not understand for unsuitable investment durations.

I have said it tens of times here and I will say it again. Long Term Gilt Funds are meant for opportunistic entry and exit. Sure, they can be part of a truly long -term portfolio (10+ years), but then I must understand that what they gain when the rates fall, they will lose when the rates rise - unless the fund manager can make a few smart buy and sell calls - theoretically possible.

Debt fund investors should understand how the NAV of a debt fund can change:

(a) To reflect the interest income the bond in the folio receive, the NAV will increase a little each business day.

(b) Longer the duration of the bond, the more sensitive it will be to interest rate changes. If the rates decrease or if there is an expectation of a decrease, the value of the older bond (with higher interest) increase. This will show as an increase in the NAV of a debt fund. This is a capital gain.

On the other hand, if the rates increase, the old bond will lose value as new bond will have a higher interest rate. This will result in a capital loss for the debt fund.

Short-term debt funds like liquid funds and ultra short-term liquid funds have minimal risk of capital loss and minimal reward from capital gains. Their primary source of returns is from accrual or interest income. Higher the duration of the bond (be it a corporate bond or govt bond), higher the sensitivity of its market price to interest rate movements.

This can be measured by a quantity known as bond yield. 

Bond yield =  interest income/ current price.

For example a Rs. 1000 bond with 10% interest rate or coupon rate will provide an interest income or coupon amount of Rs. 100. Then the interest rate = yield. Rs. 1000 is the face value of the bond or value when it was issued. Due to market forces, the current price will change and hence so will the yield.

The yield represents the return you get from the bond. The return is just the simple coupon rate based on the current price. It is not the annualised return (this is calculated with a quantity known as yield to maturity or YTM). Read more about YTM here: How to buy tax-free bonds in the secondary market

When bond prices fall, like when interest rates being to increase, the yield will increase, and vice versa. Investors who like to hold dynamic bond funds or long term gilts funds can study bond yield movements from investing.com

Go to  https://in.investing.com/markets/india

(copy url --> right-click --> "go to") and select 'bonds' tab. The following yield information is from there.

It is important to keep in mind that bond price volatility is relevant only for debt funds and those who wish to sell in the secondary market. If a bond is purchased only for interest income and held until maturity. Then unless there is a default, there should be no issues.

The Inverse relationship between Yield and Long-Term Debt Mutual Funds

In July 2013, RBI hiked the short-term interest rate to stem the purchase of short-term bonds, reduce liquidity in the market and support the falling rupee. The above graph indicates this move with a sharp increase in 10Y  yield. A rise in yield implies in fall in bond prices and hence fall in NAV.

Then the yield dropped due to the expectation of a rate cut. Therefore, there was not much movement when the rate was actually cut. Further rate cuts (arrow) results in a drop in yield. Then the demonetization triggered a sort of anti-crash. A sharp downward spike in yield leading to sudden gains in long-term yield.

However, there not been a rate cut since October 2016 and when the Feb. policy review meet also kept it unchanged, there was a sharp upward movement in yield.

That is, people now are expecting the rates to increase again. This means the demand for old bonds has come down. So they lose value and hence the yield increase. If you follow the above graph a couple of times, you can appreciate this relationship.

This is how ICICI Long term Gilt Fund behaved in this period (source: value research). You can correlate it with the above yield graph.

Here are different yield movements in the last year.  Notice the sharp up move in long-term yield after Feb 8th (RBI meet).

The best time to buy long-term gilts is when you think rates will not increase any more and sell them immediately after a sizeable gain (with tax as per slab). Of course, not many can do this and way too often, people see the high return from LT gilts and then buy. That is closing the barn door after the horse has bolted. Or as the saying goes, if you can step on three daisies, it is already spring.

It is important to recognise that the concept of yield to maturity (annualised return if a bond is held to maturity) is of no relevance in open-ended debt funds. Here the fund manager will buy and sell and also the exposure to each bond will change because of inflows and outflows. As a result, the yield to maturity, the average maturity and the modified duration* of the portfolio will change on a month by month basis. Rendering the idea of yield to maturity irrelevant.

So you cannot hope that the fund manager will hold to maturity and that the interim volatility does not matter. Gilt bonds are available for up to 30-40 years. Do you really expect fund managers to hold for that long? Or more important, do you expect to stay invested (at least in the same fund) for that long?! The volatility that you see is a real risk if you need the money soon. Higher the average maturity of the bond, the longer it will take for a fund to recover from a crash.

NPS portfolios took a year-plus to recover from the July 2013 crash. This crash played its part in PFDRA decided to introduce deferred withdrawals.

I will update this graph to account for recent movements soon.

*The modified duration is a measure of how sensitive a bond is to in interest rate movements. You can learn more about this here: Understanding Interest Rate Risk in Debt Mutual Funds.

Here is an example of ICICI long term gilt fund portfolio for the last four months. In this time, the month returns were quite volatile (source: VR)

This is the portfolio (source fund factsheets). If you have trouble viewing it, here is the excel file.

Notice that the average maturity changes from 17 years to 23 years in four months!  Each month, long term gilts were sold or purchased - either new ones or more of the same (observe the folio weights). Here 8.13% GOI 2045 means, a GOI bond maturing in 2045 with a coupon rate of 8.13%.

About 7 long term bonds were held constant over these four months, but the total exposure of these bonds changes from 68.7% in Nov 2016 to 90.71% in Dec 2016 and then back to 53.81% in Jan 2017 and 57% in Feb 2017.

I do not wish to speculate as to what the fund manager was trying to do, but it is clear that he was quite active!

You may have heard people talk about "reaping rewards if one stays invested over the long term" when it comes to equity funds. I don't know about equity, but it is quite possible with long term gilts, with two caveats: (a) long-term means several years - I would say 10+ and (b) it will be quite a bumpy ride with the gains made during rate cuts almost erased during rate hikes.

Whether such unproductive volatility is needed or not, is a question that you need to ask. In any case, at least for all other purposes, I would recommend staying away from long-term gilts.

If you wish to learn more, download this Free E-book: A Beginner's Guide To Investing in Debt Mutual Funds.

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