What are gilt mutual funds and who should invest in them

By Dr Neelam Rani and Darshan Gosalia

Gilt mutual funds have specific characteristics and are suitable for certain types of requirements in investing. However, before we discuss the suitability of these as an investment it is important to understand how these funds work.

What is a gilt fund and how does it work
Gilt funds are a type of mutual funds that invest specifically in Central Government or State Government securities (G-secs) which are fixed-interest bearing in nature.

When the government has a funding requirement, it borrows from the Reserve Bank of India (RBI). To meet the government’s funding needs, RBI collects the required amount from the banks and insurance companies and routes it to the government. In exchange of such funding received from various institutions, RBI issues g-secs of fixed tenure on behalf of the government. Gilt funds subscribe to these securities. At maturity, gilt funds return g-secs and receive a payout in return.

The primary differentiator between a gilt fund and other debt funds is that gilt funds invest in securities which are guaranteed by the government. They are 100% backed by the government and thus, the risk of non-fulfilment of its repayment obligation is miniscule in some cases and absent in most of them.

Investment considerations
In order to determine whether gilt funds should be included in the debt portfolio of the investors, the financial goals and aspirations of the investor should align with the investment considerations.

Historical performance and returns
Historically, gilt funds have provided a positive return to investors over the past ten years. More specifically, the performance of gilt funds during the past two years has been tremendous. Most of the gilt funds have provided a double-digit return during the past two years, whereas some of them have returned as high as 14%. This is significantly higher than the interest rates offered by various banks on fixed deposit. The investors who had invested in gilt funds especially stood to gain in the scenario of falling interest rates during the past two years. Predictably, investors’ traction in gilt funds is also on the rise. The gilt funds witnessed a net inflow of ?2,516 crores in April, as per the data published from the Association of Mutual Funds in India.

However, an important caveat in respect to the performance of gilt funds is that though the repayment obligation is guaranteed, the returns from the gilt funds are not guaranteed and are highly volatile with the changes in the overall interest rates. Gilt funds are expected to deliver tremendous returns during economic turmoil when the interest rates are falling. However, the rising interest rates would necessarily provide lower to negative returns on investments in such gilt funds. The major risks associated with gilt funds are discussed hereunder.

Risks associated
The two major risks to be considered while investing in gilt funds are credit risk and interest rate risk. Credit risk refers to the inability of the borrower to pay the debt obligations as they become due. As discussed earlier, the underlying assets of the gilt funds are g-secs backed by the government. Thus, the popular belief is that gilt funds do not have credit risk as government usually does not default on its repayment obligations. This concept is easily understood by the investors and this is the main reason why the investors are attracted to invest in gilt funds.

What is usually not understood is that though gilt funds are free from credit risk, they are highly sensitive to interest rate fluctuations and are subject to interest rate risk. Interest rate risk refers to the change in price due to change in interest rates. There is an inverse relation between the interest rate and the NAV of gilt fund scheme. An increase or decrease in the interest rates results in a consequential fall or rise in the NAV of the gilt fund. This leads to fluctuation in the fund’s returns. In fact, extreme volatility in returns of gilt funds has made them the riskiest investment class in the debt fund category. The impact of interest rate fluctuation can be so intense that it may lead to substantial reduction in the NAV of fund resulting in negative returns in the short-run.

When the interest rates are falling in the economy due to various measures taken by the RBI, the investors receive lesser amount in terms of interest by depositing the amount in banks. The gilt funds have higher yields in such circumstances than the bank interest rates. Thus, the demand for gilt funds rises which results in the rise in the price of gilt funds. As price and yield are negatively related, the rise in price of gilt funds leads to fall in the yields. Thus, when the interest rates are expected to decline, the price of gilt funds would rise. Applying a similar analogy to the scenario of rising interest rates, the price of gilt funds would decline due to increase in interest rates. Thus, it is favourable for the investor to invest in gilt mutual funds if the interest rates are expected to decline. However, it is important to constantly monitor the movement in interest rates as it has substantial impact on the price of the gilt funds and consequentially its return.

Like other mutual funds, Gilt funds also charge an annual fee to cover the fund manager’s fees and other related expenses. The ceiling on this annual fee or expense ratio is 2.25% of the asset under management. However, the actual expense ratio may differ from fund to fund. Thus, investors should quantify the impact of expense ratio on the expected return of the fund while deciding on investing and evaluating the performance of a particular fund.

Investment horizon
Gilt funds have long-term investment horizon. Presently, most of the gilt funds in India are running at an average maturity of more than 7 years. Thus, the investor should take a long-term view of his financing requirements while investing in gilt funds.

Exit route
The exit options available to the investor of a gilt fund are similar to that of any other mutual fund. The exit route depends on whether the fund is an open-ended fund or a closed-ended fund. For an open-ended fund, the available exit routes are – sale in the secondary market, redemption post the lock-in period but before maturity, redemption on maturity, switch-ins and systematic withdrawals. For a closed-ended fund, the available exit routes are – sale in secondary market and redemption on maturity.

Capital gains arising on account of investment in gilt funds is fully taxable. In case the gilt funds are held upto 36 months, the gains would be charged as Short-Term Capital Gains (STCG) tax as per the individual’s slab rate. If the gilt funds are held for more than 36 months, the gains would be charged as Long-Term Capital Gains (LTCG) tax at 20% (with indexation benefits). Investors seeking investment in gilt funds should evaluate their potential returns on net basis after taking into consideration the implications of capital gains tax.

Debt allocation framework
The investor should allocate their debt portion of their portfolio in three buckets – liquid bucket, core bucket and satellite buckets. Liquid bucket refers to the funds which can be immediately encashed upon in order to meet your short-term liquidity requirements. Core bucket consists of funds which have high credit quality such as AAA rated bonds and have investment horizon similar to that of a fixed deposit i.e. one to three years. Satellite bucket consists of funds having lesser credit quality than the core bucket or have a longer duration. Gilt funds have a longer maturity than core bucket funds. Further, though gilt funds do not have credit risk, they have very high interest rate risk. Thus, it is advisable to look at the investment in gilt funds from the satellite bucket point of view.

In terms of allocation of the debt portion of the portfolio, the investors should invest at least 80% in liquid and core buckets and a maximum of 20% in satellite bucket.

Who should invest
Summing up the discussions above, investment in gilt funds is suited to the following type of investors:

  • Investor who possess technical knowledge and can constantly monitor movements in interest rates or has access to professional investment managers to look after the same;
  • Investors who only want to invest in low credit risk securities;
  • Investors seeking to diversify their debt portfolio by including gilt securities under satellite bucket.

Covid-19 implications and way forward
The portfolio managers of gilt funds constantly monitor the interest rate fluctuations and take proactive stance of cutting down the duration in case of a likely rise in interest rates. However, the global environment was weak much before the world entered the Covid-19 pandemic. On account of Covid-19, most of the countries in the world are facing recessionary conditions and experts expect India’s GDP to contract in the current fiscal. Under this backdrop, the likelihood of in interest rate hike is unlikely. However, under unforeseen circumstances, if there is a hike in the interest rates, then there may be a negative impact on the returns from gilt funds and its impact may vary depending on the average maturity of the fund.

The investors should consider investing in gilt funds if they possess the qualities discussed above. Also, a holistic understanding of various risks and investment considerations should be looked at before investing in gilt funds. Lastly, the probable impact of economic environment in general and Covid-19 in particular should be paid special emphasis while investing in gilt funds.

(Dr Neelam Rani is an Associate Professor (Finance) at IIM Shillong; Darshan Gosalia, is a Chartered Accountant and PGP 2019-21 Student at IIM Shillong.)

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