Gilt Funds - Meaning, Risk, Returns and its Alternatives

What are Gilt Funds?

Gilt funds are the debt mutual fund schemes that invest in the securities issued by the Central or State Governments. As per SEBI mandates, the Gilt Funds need to have at least 80% of their assets invested in government securities. However in practice, most of the funds in the gilt funds’ category have invested almost all of their assets in G-securities with varying maturities. The securities or bonds issued by the government are generally used for funding the infrastructural or developmental activities related to the economy.

Therefore, Gilt funds lend to the central & state governments by way of investing in the bonds issued by them. In this way, these funds are one of the safest instruments in terms of credit quality in the debt category, as the chance of a default is negligible, with respect to maturity proceeds or the coupon payments. High safety of capital backed with the sovereign guarantee on the underlying securities makes these funds very attractive for the risk-averse investors. 

But still, there are many important things that need to be considered before investing in these funds. No doubt, these funds offer the avenue for high capital protection (& guaranteed coupon payments) to the investors but on the other side, they carry high-interest rate risks due to the high modified durations & maturities exhibited by the underlying securities. The high risk associated with the interest rate movements is expected to exhibit high volatilities in returns over the short periods. And this makes these funds suitable to be included in the portfolio not for everyone but for specific investors with long horizons.

As can be seen from the picture above, in the last few months the Gilt funds category has seen huge inflows. This has been caused primarily due to the liquidity issues and fear of default caused by the Covid-19 pandemic. Investors have preferred to shift their debt investments to these funds because of the zero credit risk feature they carry.

Risk Factors

  • Liquidity Risk

Liquidity risk which is essentially the risk associated with the security or bonds being not actively traded in the market and therefore sometimes which becomes difficult for the manager to sell the securities in the market for meeting redemptions is negligible in the gilt funds. As the underlying securities are issued by the government, there is no credit risk in these securities. So these securities are actively traded in the secondary markets and even gain high traction among investors during the gloomy times in the economy because of their safety.

With hardly any liquidity risk, these securities are amongst the categories of funds providing the highest liquidity to the investors.

  • Credit Risk: 

Credit risk is the risk associated with the default on payments (both principal and coupon payments)  being made by the issuers. The Gilt funds have zero credit risk because of the sovereign guarantee on the securities issued by the government.

Investors need not worry about the quality of assets as the Gilt funds invest only in sovereign securities which have the highest credit quality.

With zero credit risk, these funds are the safest among all the 16 categories of the debt funds.

  • Interest Rate Risk

Interest Rate Risk is the risk associated with the sensitivity of the fund's NAV to the interest rate movements in the economy. Gilt funds carry very high-interest rate risks because of the long maturities & high modified durations of the underlying G-securities. This is why these funds are extremely volatile over the short periods.

  • In the falling interest rate scenarios, the Gilt funds experience high positive returns as the demand for the government securities rises among investors owing to their offerings of relatively high-interest rates (where newly issued securities will carry low-interest rates) along with providing the guarantees on the investment & coupon payments. The rising demand of the previously issued securities in the market results in the scenario where these bonds start trading at higher prices and therefore the NAV of Gilt funds rises.

Whereas in the rising interest rate scenarios, the Gilt funds are likely to experience sharp falls and sometimes even show negative returns. This is because the investors are likely to shift to newly issued securities or bonds which offer higher interest rates compared to the old ones. This further leads to falling demand in old bonds & their prices start falling. Which lowers the NAV of Gilt funds and therefore their returns would fall.

Also Read: Best Mutual Funds to Invest in for Long Term in India

Parameters to evaluate Risk in Gilt Funds

  • Modified Duration

Modified duration is the parameter used to evaluate the sensitivity of the price of underlying bonds to the interest rate movements in the economy. For example- In response to the 1% rise/fall in interest rates, a fund with a modified duration of 5 years would fall/rise by 5%.

The funds with the higher durations are expected to respond with high movements in response to the interest rate changes. So, the Gilt funds with low durations could be preferred for investments as they would be less volatile as compared to the ones with higher modified durations. 

Currently, the average modified duration in the Gilt funds category is 6.47 years.

  • Average Maturity

Average maturity is simply the weighted average maturities of all the underlying securities in the fund. A fund invests in securities with varied maturities, so the average maturity is obtained by making calculations regarding the average time at which all the securities will mature by using a weighted average method (calculated on the basis of years to maturity & amount of investments).

The funds with longer average maturities are expected to exhibit higher volatilities and vice-versa. Funds with long maturities are likely to show higher fluctuations in response to the interest rate changes in the economy. Whereas funds with shorter maturities are expected to exhibit low volatility & less fluctuations in their NAVs in response to interest rate movements.

So, the Gilt funds with relatively shorter maturities could be preferred over the longer ones. Also, Investors can look at the average maturity of different schemes to select the ones aligning with their investment horizon.

Currently, the average maturity of the funds in the gilt funds category is 10.04 years.

  • Yield to Maturity

Yield to Maturity is basically the returns expected from the fund if the underlying securities are held by the investors till the maturity.

The YTM of the fund is the average YTM of the underlying securities and is subject to changes with the interest rate movements, bond value changes & changes in ratings. The funds with higher YTMs are expected to exhibit higher risks & volatility in the portfolio.

Currently, the average Yield to Maturity in the Gilt funds’ category is around 5.86% which means that the investors will earn returns of 5.86% if he/she holds the fund till the maturity of the underlying securities.

Along with the above-mentioned measures, the investors could also look at the funds with taking into account the taxability factor. 

Who should invest in Gilt Funds?

Gilt Funds come with zero credit risks but carry high-interest rate risks. It would not be prudent for the investors to give attention only to the fund's zero credit risk and invest just for the sake of the underlying securities carrying sovereign guarantees. Because with the high fluctuations that these funds have to encounter, the returns might even go to negatives sometimes in the very short run. Moreover, as the average maturities of these funds are generally very long i.e around 10 years, investments in these funds for short periods could result in high capital losses because of the extreme volatility they exhibit. 

Gilt funds are not suitable for all kinds of investors. Only those investors who understand these risks well and are prepared enough to face these risks could look at investing in these funds. Talking about the investors with respect to time horizon & risk appetite, the investors who are risk-averse and have an investment horizon almost matching with the average maturity of the specific fund should consider making investments provided they are ready to accept the high volatilities in the short run.

Investors with short horizons

It is very difficult to time the markets & economic events like the drop or rise in the interest rates in the economy. The investors who believe they can predict the movements of interest rates can look into making short term investments as the gains could be very high over the short periods in the falling interest rate scenarios. Timing of entry & exits is very important in this strategy. However, it is very risky to adopt this strategy which should be practiced only by professionals and should be avoided if the investor is not sure of the interest rate movements.

Top Gilt Funds

Some of the top gilt funds in terms of past returns are:

FundsAUMYield to MaturityExpense RatioNet YieldMDAverage Maturity1 year3 years5 years10 Years
IDFC Government Securities Fund10666.031.14.936.158.2315.619.6710.3410.06
SBI Magnum Gilt Fund27526.270.955.327.5912.9313.818.5410.179.88
DSP Government Securities Fund11736.11.095.017.110.715.029.169.958.13
Nippon India Gilt Securities Fund13816.051.714.346.7710.4913.529.2410.599.54
Category 5.86  6.4710.0412.117.879.178.79

1. IDFC Government Securities Fund:

IDFC Government Securities fund has performed consistently over the last 10 years. The fund has generated highest returns in the category consistently over the short as well as long period.

The Fund has been managed by Mr. Suyash Choudhary since October 2010.

Analysis

The Yield to Maturity of the fund is slightly higher than the category average of 5.86% which would mean above average YTM can be expected from this fund. The expense ratio of the fund (1.1%) is slightly lower than the category average of 1.16%. Lower expense ratios than the category average would mean the investors will earn pocket more returns post expenses.

The modified duration of the fund is higher than the category average of 6.47 which means that the fund is expected to exhibit higher fluctuations in response to interest rate movements as compared to others. The average maturity of the fund is also higher than its peers’ average of 10.04 years.The standard deviation which measures the volatility of the fund is higher than the metric number of the category.

Higher modified duration, higher maturity & higher standard deviation of the fund points out to the expected high volatility that the fund might experience.

2. SBI Magnum Gilt Fund

SBI Magnum Gilt fund has been a good performing fund over the long periods by delivering returns higher than its category average.

The Fund has been managed by Mr. Dinesh Ahuja since January 2011.

Analysis

The Yield to Maturity of the fund is significantly higher (infact one of the highest) than the category average of 5.86% which would mean higher returns can be expected from this fund, however with higher YTM comes with higher risks. Also,the expense ratio of the fund (0.95%) is lower than the category average of 1.16% would mean the investors will pocket more returns post expenses if they hold till the maturity.

As the fund offers higher YTM, it is natural that the modified duration & average maturity of the fund are expected to be higher. The modified duration & average maturity of the fund are significantly higher than its peers’s average of 6.47 years & 10.04 years which would mean that the fund is expected to exhibit higher fluctuations in response to the interest rate changes or any other economic events in the economy. The standard deviation which measures the volatility of the fund is lower than the numbers of the category.

Though the standard deviation is currently lower than its peers, looking at the high modified durations & high average maturity of the underlying bonds it could be expected that the fund will respond with higher fluctuations or volatilities.

3. DSP Government Securities Fund

DSP Government Securities Fund has been a good performing fund over the long & short periods. The fund has generated above average or higher returns than the category for the last 5 years consistently. However looking at the long term performance, the returns have been lower than its category average but it would not be right to just rank the fund based on its returns rather the other important parameters like YTM, average maturity should also be taken into account. Let’s take a look at them.

The Fund has been managed by Mr. Saurabh Bhatia since March 2018 and Mr. Vikram chopra since July 2016.

Analysis

The Yield to Maturity of the fund(6.10) is higher than the category average of 5.86% which would mean above average YTM returns can be expected from this fund, if the investors hold till the maturity. The expense ratio of the fund(1.09) is slightly lower than its category average of 1.16%. So, the Net yield of the fund comes out to be higher. 

The modified duration of the fund (6.77) is also slightly higher than the category average of 6.47 which means that the fund is expected to exhibit higher volatilities in response to the interest rate changes as compared to others. The average maturity of the fund (10.49) is slightly higher than the category’s average maturity of 10.04 which is  expected to exhibit higher risks or fluctuations as compared to its peers.The standard deviation which measures the volatility of the fund is lower than the metric number of the category.

Though the standard deviation of the fund is lower as compared to the category, higher modified durations & higher average maturity than the peers point out to the higher fluctuations that the fund might experience.

4. Nippon India Gilt Securities Fund

Nippon India Gilt Securities Fund has been a performing fund over the long periods. The fund has generated above-average or slightly higher returns in the category consistently over the short as well as the long period.

The Fund has been managed by Mr. Prashant R Pimple since June 2020.

Analysis

The Yield to Maturity of the fund is slightly higher than the category average of 5.86% which would mean above average YTM can be expected from this fund. However, the net yields i.e post expenses come out to be lower for this fund because the expense ratio of the fund (1.71%) is significantly higher than the category average of 1.16%. Higher expense ratios & Lower Net Yields compared to the category average would mean the returns are expected to be lower post expenses if the fund is held till maturity.

The modified duration of the fund (6.77) is also slightly higher than the category average of 6.47 which means that the fund is expected to exhibit higher volatilities in response to the interest rate changes as compared to others. The average maturity of the fund (10.49) is slightly higher than the category’s average maturity of 10.04 which is  expected to exhibit higher risks or fluctuations as compared to its peers.The standard deviation which measures the volatility of the fund is lower than the metric number of the category.

Though the standard deviation of the fund is lower as compared to the category, higher modified durations & higher average maturity than the peers points out to the higher fluctuations that the fund might experience.

Gilt Funds Alternatives

1. Banking & PSU Funds

Banking & PSU funds are debt mutual funds that invest at least 80% (allowed to invest 15% from 80% in g-secs for a short period) of its assets in the debt securities issued by the banks, public sector enterprises and financial institutions.

  • Investments in Banking & PSU funds involve very low credit risk because of their exposures in high credit quality papers of the public sector entities.
  • The Banking & PSU funds are less sensitive to the interest movements as compared to the Gilt funds because of the low average maturities & modified durations.
  • Investors having low risk appetite along with an investment horizon of at least 3-5 years should consider investing in these funds.

Banking & PSU funds are a great alternative to the Gilt funds as they carry very little credit risk (though higher than gilt funds) and are better than the Gilt funds in the way that they are comparatively less sensitive to interest rate movements and therefore exhibit lower volatility.

2. Bharat Bond ETFs 

Bharat Bonds ETF is a government-backed product which is exclusively managed by the Edelweiss AMC. The ETF invests in a basket of debt securities or bonds issued by the public sector units, enterprises & financial institutions with credit ratings of AAA. These bonds are available for the durations of 3 years & 10 years. The NFO for 5 year & 11 years ETF scheme will be open for subscription between 14 july to 17 July 2020.

  • As the Bharat Bond ETF invests only in the AAA-rated high-quality securities, the ETF carries very low credit risks and therefore has a high level of safety.
  • The Bharat Bond ETFs invest in the underlying securities in a way that their maturity closely matches with the target maturity of the ETF.
  • A roll down strategy used by the fund ensures that investors need not worry about putting their money into less volatile instruments before the maturity as it will automatically invest in the securities as per the target maturity
  • Investors with low to moderate risk appetite could look into investing in the different ETFs available as per their investment horizon.

Bharat Bond ETFs can be a great alternative to the Gilt funds because of the low credit risks and targeted maturity strategy where the underlying securities mature by the maturity of the ETF and thereby volatility reduces overtime.

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