Why are Indian Gilt Funds seeing consistent outflows?
As the Bloomberg chart above indicates, Indian Gilt Funds have been seeing consistent outflows over the last four months from February onwards. What explains these outflows? But first, what exactly drives Gilt Fund inflows?
It’s all about rate expectations…
Gilt funds are funds that invest largely in government securities of a longer term. Apart from being liquid, these Gilt Funds are the most vulnerable to changes in the market interest rates. Gilt funds typically benefit when interest rates are moving down as falling yields results in an appreciation in G-Sec prices. This capital appreciation is what most investors in Gilt Funds actually play for. Interest rate expectations are driven by the repo rate signals provided by the RBI in its bi-monthly monetary policy, The RBI view on rates, in turn is influenced by the outlook on inflation. In its latest policy, the RBI refrained from cutting rates because inflation for April had shot up to 5.39% from 4.83% in March. This higher inflation reduces the chances of a rate cut by the RBI.
So it is all about inflation?
Eventually, the yield on gilts is a function of inflation expectations. When investors expect that inflation will be higher, they estimate gilt yields to go up and therefore the gilt prices to go down. This will lead to negative returns on gilt funds and therefore leads to outflows. But why are inflation expectations high? Firstly, India is just coming out of 2 years of drought which had played havoc with food prices. Food constitutes the major sticky component of CPI inflation. Hence markets are taking the IMD’s rosy monsoon forecasts with a pinch of salt. Secondly, the current fiscal entails additional payment of nearly $16 billion on account of 7CPC payouts and OROP payouts for defense personnel. Such an infusion is obviously inflationary and is likely to manifest with a lag. Lastly, the FCNR redemption will entail a payout of $25 billion this calendar year.
Don’t forget the Fed angle…
There is also an interesting Fed angle to it. As negative interest rate bonds have grown to $10 trillion, the US Fed realizes that it has to take the lead in getting rates into positive territory. That is the only way to kill asset bubbles. If the US Fed turns hawkish, as it continues to be, the RBI would have second thoughts about cutting rates. That would mean higher bond yields in India. The Gilt Fund outflows may continue with limited visibility of lower bond yields in India! ©