What are Gilt Funds? | Should I Invest? | Risks in Gilt Funds?

Is It a Good Time to Invest in Gilt Funds? Are Gilt Funds Risk-free?

Introduction

Gilt Funds and Gold are the only two categories, which were able to deliver a good double digit returns over the last 1 year. What are Gilt funds? Why they performed so well as compared to the other debt funds? Is It a Good Time to Invest in Gilt Funds in 2020? Are these funds risk-free? Let us discuss everything about Gilt Funds in this article.

The recent clsosure of 6 debt schemes by Franklin Templeton Mutual Fund has added a big concern to the debt funds investors. In spite of the current stressful environment in the debt funds categories, Gilt Funds have had a solid run with 11-15% returns (a bit more for direct plans) over the last 1 year.

What are Gilt Funds?

Explanation

• Gilt Funds are also known as G-Sec Funds or Government Securities Funds.
• Basically, Gilt Funds are the debt funds which only invest in Government bonds and fixed interest-bearing securities issued by the state and central governments.
• Gilt Funds are pure debt funds, there is no allocation to the Equity component in their portfolio. Thus, there is no Equity Risk associated with the stock market as such.
• According to the SEBI mandate, Gilt Funds have to invest minimum 80% investments in the Long-term Government Securities.
• So, if we compare the current asset allocation of the Gilt funds with the historical asset allocation,
  • In March-2017, there was 92% allocation for the Government securities.
  • While in March 2020, almost 99% of the allocation is in Government securities.

Risk Analysis of Gilt Funds

• Credit Risk
  • As we mentioned above, Gilt Funds solely invest in Government instruments having varying maturities, since the Government securities are of various tenures.
  • As the bonds and securities issued by the government bear sovereign guarantee, such securities are completely safe. So, there is almost zero credit risk.
• Liquidity Risk
  • Gilt funds and underlying securities are traded in the secondary markets, the prices vary according to the current interest rates.
  • Unlike Corporate bond funds, Gilt funds are the most liquid instruments as they don’t carry credit risk.
  • Since the money is invested with the government, these funds are said to carry minimal risk.
• Interest Rate Risk
  • Gilt funds primarily suffer from an interest rate risk. In case of Debt category funds, the interest rate risk is the highest risk associated with the fund.
  • The net asset value (NAV) of the gilt fund drops sharply during times of an increasing interest rate regime.
  • Thus, Gilts can be highly volatile as they are sensitive to the interest rate movement, since the government borrowings typically happens to be for a longer duration.

Government Securities

• Basically, Government securities are the bonds or the debt papers issued by RBI on behalf of the Government.
• These Government securities have the maturity of more than 1 year.
• They have a good secondary market.
• The Government Securities can be bought and sold by the retail investors as well.
• A Sample Structure of how RBI issues Government securities is shown below :

Gilt Funds Returns

• Here, we have calculated the Gilt Funds Category Average Returns, both :
  • Trailing Returns
  • Calendar Returns
• On our MF Yadnya website, we have analyzed and done a comprehensive review of mutual funds.
• Trailing Returns
  • As per the Gilt Funds category analysis considering top 10 funds, the Trailing returns of category average for 1 year is 12.8%.
  • There has been Gilt Funds with 15-16% returns, whereas some Gilt Funds have shown 9-10% returns.
  • So, accordingly, the Category average trailing 1 year return came out to be 12.8%.
  • Similarly, the Trailing returns of Category average for 3 years and 5 years were 7.9% and 8.7% per annum respectively.
• Calendar Returns
  • The calendar Returns of Gilt Funds Category Average is also shown in the above chart.
  • The graph gives us the clear picture about the how high is the volatility in the Gilt Funds’ returns. This volatility is purely because of Interest Rate risk.
  • Also, there is not much consistency in the returns. Since last 3 years, the Calendar returns are improving sequentially just because of the falling interest rate cycle.
  • Thus, there is no credit risk, no liquidity risk in case of Gilt Funds. All the fluctuations in the Returns are primarily driven by only interest rates risk.

How Interest Rates of the Securities are Different in different time period?

• Lets take an example. RBI has issued Governments securities of Rs.17,000 Cr in June-July 2019 and Rs.30,000 Cr in June 2020.
• The details of these 2 auctions are sourced from the RBI’s website.

• Here, we can clearly see that :
• In last year Auction period June 28-July 1, 2019, the Governments securities are issued at the G-Sec interest rates 7.00% to 7.63% depending upon the maturity of the bonds.
• While, In the recent Auction period – June 5-8, 2020, RBI has issued the Governments securities worth Rs.30,000 Cr at the G-Sec interest rates in the range 5.09% to 7.19% depending upon the maturity of the bonds.

How come the G-Sec interest rates have declined in 2020 issue?

• It is purely because of the falling interest rates cycle – a series of policy Repo Rate cut by RBI since last 1 year.
• RBI is cutting the Repo Rate as well as Reverse Repo rate mainly to push the economy. RBI is trying to boost the credit growth for the economic development, which thereby contributes the GDP growth.
• Thus, the Interest Rates of the Securities are Different in different time period depending upon the benchmark policy rates at the time of issue.
• In case new government bonds and securities are issued at a lower interest rate, price of old papers with higher interest rate are traded at a higher price, raising the NAV of the existing gilt funds.
• Also, The G-Sec rates for the longer Maturity is higher. It is because higher the Maturity of the bond, higher will be the interest rate risk the investor has to bear. So, in order to compensate the added Interest Rate Risk, the G-Sec rates of Longer Maturity papers are kept higher than that of lower Maturity papers.

Interest Rate Movement in India

• As we discussed above, Gilt Funds carry a high Interest Rate Risk, because of the longer Maturity of underlying Government securities.
• Therefore, the impact of Interest Rate movement on the performance of Gilt Funds need to be analysed thoroughly.
• The net asset value (NAV) of the gilt fund drops sharply during times of an increasing interest rate regime.
• On the other hand, in case of Falling Interest Rate regime, the NAV of Gilt Funds jumps sharply, delivering the higher returns.
• In short, the Falling Interest Rates Cycles are Favourable for Gilt Funds.

Investment Horizon of Gilt Funds

Average Maturity

• The Average Maturity of the underlying Government securities, which Gilt Funds hold is around 9.2 years.
• Here, we have compared SBI Magnum Gilt Fund with Gilt Fund Category Average.
• The average maturity of the securities of SBI Magnum Gilt Fund is around 10.2 years.
• Thus, the more the Maturity of the Gilt Fund, the more is the Interest Rate risk the fund carries.

Modified Duration

• The responsiveness of the Gilt fund to interest rate changes is given by a measure called Modified Duration.
• Here, the Modified Duration of Gilt Fund Category Average is 6.3 years, while that of SBI Magnum Gilt Fund is 7 years.
• For Example : A modified duration of SBI Magnum Gilt Fund is 7 means that a 1% cut in interest rate will cause a roughly 7% gain in the fund.
• Basically, Modified Duration is used in bond valuation, which expresses the change in the value of the bond due to the change in the interest rates.
• Long-duration funds like Gilt Funds which have modified durations of above 5-6 are hypersensitive to interest rate movements. The investor can pocket huge gains or losses based on interest rate changes.

Yield to Maturity (YTM)

• If you are planning to invest (for long term) in Gilt Funds, do consider the YTM.
• What is YTM?
• If you are investing in a Gilt Fund till the Maturity date of the underlying securities, then the rate of return it will generate is called as Yield to Maturity (YTM).
• For example : The YTM of SBI Magnum Gilt Fund is 6.5. Then if you hold the investment for the Long-term, you will surely get the rate of return 6.5% per year.
• The YTM of the fund not only indicates the returns, but also the risk of the underlying portfolio of the fund. Higher the YTM, higher is the risk associated with the fund.
• So, investor should also consider the YTM of Gilt fund if planning to invest for Long-term.

Summary

• Gilt Funds carry the highest Interest Rate Risk
  • They are suitable when interest rates in the economy are expected to come down.
  • Investing in gilt debt funds can be a safe investment if the timing of buying is accurate (linked to interest rates).
  • Investors should make sure that they don’t invest in gilt funds when the interest rates have formed a base (bottom).
• Not for all investors
  • Gilt Funds are highly volatile in nature, might see volatility during times of important economic events.
  • Investor who want to invest for very Longer tenure, then only Gilt Funds are suitable for you.
• Very Risky for short term investment
  • You should not invest in Gilt funds for 1-2 years, since they are very risky for short-term.
  • If you want to invest in long-term gilt funds, falling interest rate cycles are favourable, but don’t try to time the interest rate trend. Consider the best funds for investment.
• Investment horizon should match with Average Maturity of the fund
  • One should check the average maturity of the underlying Government securities of the Gilt Fund.
  • At our MF Yadnya website, we have analyzed the Gilt funds and rated them based on the parameters like Interest Rate risk, Average Maturity, Modified Duration, YTM etc.