The best-performing asset class in the year to date is also low down the risk scale – government bonds, also known as Gilts.
As the table shows, Gilts have outperformed all other asset classes by a wide margin in the year to date. Gilts have generated holding period returns of around 13% while the other asset classes have given negative returns varying from -4.5% to -56%.
On the risk scale, gilts are the least risky of asset classes, carrying no credit risk and low liquidity risk. The only risk they carry is the interest rate risk and the interest rate cycle is clearly turning positive at present.
Interest rate cycle turning positive
The direction of interest rates is down. This is clear from the fact that the global economies as well as the domestic economy are seeing a significant slowdown in growth.
The forecasts for global economy by economists across global investment banks and global financial institutions are being revised downwards from around 4-4.5% in calendar 2008 and 3.5-4% in calendar 2009.
The global growth forecasts are now in the range of 3-3.5% and 1.5-2% for 2008 and 2009, respectively.
The forecast for fast-growing emerging economies is also being revised downwards with 2009 growth being revised from 6.5-7% to 5-5.5%. Advanced economies are expected to go into recession in 2009.
Indian growth forecasts have been revised downwards for 2008-09 from 8.5-9% to 7-7.5%.
The downward trend in global growth has led to demand destruction on the back of slowdown in consumer spending. The fallout of the demand destruction is seen in commodity prices, which have crashed. Oil prices are off by close to 50% in the year to date, even as the Reuters
Commodity Index, which tracks a basket of commodities, is down by 35%.
The sharp fall in oil prices has led to significant lowering of inflation expectations. In India, inflation as measured by the Wholesale Price Index (WPI) is off sharply from highs of over 12.5% seen in August 2008 to levels of 8.9% in November 2008.
Inflation is expected to trend down to below the Reserve Bank of India’s (RBI) target of 7% for March 2009, on the back of growth slowdown and fall in commodity prices.
The growth slowdown as well as the sharp fall in inflation expectations has led to central banks across the world cutting policy rates in order to spur growth. The RBI has also followed global central banks in reducing benchmark policy rates. It has reduced the repo rate by 150 basis points (bps) from 9% to 7.5% and the cash reserve ratio (CRR) by 350 bps from 9% to 5.5%. The RBI is expected to reduce rates further in order to spur a flagging economy.
Gilts to outperform
Gilts have outperformed all other asset classes in the year to date and are likely to maintain their outperformance in calendar 2009. Gilt outperformance will be on the back of growth slowdown and disinflation/ deflation brought about by demand destruction worldwide.
The stress on growth will keep equity and commodity prices down, while credit spreads are likely to widen on the back of stress in corporate balance sheet.
The downward shift in the growth curve has caught on the wrong foot the corporates who were leveraged for continuous growth. The corporate sector is now faced with a lack of liquidity and balance sheet stress, two factors highly negative for credit spreads.
The mutual fund industry is highly underexposed to the best performing asset class in the year to date as well as the least risky of asset classes.
The assets of all gilt funds put together is Rs 3,500 crore, which is just over 1% of the total fixed income assets of Rs 300,000 crore (as of October 31, 2008).
The industry is highly exposed to credits, an asset class likely to underperform gilts as well as carrying credit and liquidity risk.
Mutual fund investors should therefore look to increase exposure to gilts, given the downward trend in interest rates. Exposure to gilts will also significantly reduce credit and liquidity risk in an investor’s portfolio. Further, gilts will provide a good hedge against recession/ deflation with returns coming from capital gains (prices of government bonds go up as yields/ interest rates) fall.
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