Should you be swayed by the last 12-months returns of Gilt Funds?

Saurabh Prabhu
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Saurabh Prabhu

Should you be swayed by the last 12-months returns of Gilt Funds?

Gilt funds invest in Government securities (G-Secs), which are the most secured instruments, as it has backing of the Government and therefore do not carry default risk.

Gilt funds AUM have been on a very strong footing over the last few months, as investors seek safer pastures for investments and focus more on capital protection rather than wealth creation. Even before the Covid-19 pandemic hit the world and capital markets, domestic factors such as the downturn in equity funds due to slowdown in domestic growth, defaults in credit risks funds and continuous reduction in repo rates by RBIled to gilt funds finding favour among the investors.Gilt Fund AUM grew by a staggering 26.3% during past 12-months ending March 2020. Even in April 2020, the gilt fund AUM grew by a further 10.6% on m-o-m basis to INR 11,315 Crore.


Trend in AUM of Gilt Funds


Source: AMFI


Trend in 10-Year Government Bond Yields

Source: CCIL

The continuous drop in 10-year bond yields has led to rally in Government bond prices thereby providing healthy returns to gilt funds investors. SBI Magnum Gilt fund (Growth) generated return of ~11.9% over the last 12 months owing to softening yields.

However, past returns are never the right indication of future returns.The Covid-19 Pandemic situation has led to an increasing interest in this asset class asalongwithsafety the gilt funds also boasts of excellent return profileover past 2-years. However, the investors must also appreciate the risks associated with Gilt Funds and then take their investment decisions


How do Gilt Fund Returns work?

The Gilt fund returns are linked to the bond prices of Government securities. The demand (which impacts the bond price) in-turn is linked to the yields or YTMs – Yield To Maturity (expected returns for investor) provided by the Government securities. Bond Prices and Yields are inversely related.

For example, the 10-year Government bond (6.25 GS 2029 – 6.25 is the coupon rate or annualized interest rate and 2029 is the bond expiry year) is currently trading at a yield of 5.98%. This means that if an investor invests today and holds the bond till maturity i.e till 2029 he/she will earn a return of 5.98%. However, if RBI increases repo rate 6 months down the line due to inflationary pressures (or any other reason), the investors will expect a higher yield and therefore sell the existing bonds due to low returns and look to invest in other products with higher yields. This will lead to a drop in the returns for the existing investors of Government Securities and Gilt Funds.Also note that, the new bond issuances by Government will likely provide higher coupon rates than the last issued tranche due to higher interest rates in the system.

An increase in repo rates by RBI will therefore have negative impact on Gilt Fund returns. Further, the Government bond yields are also exposed to Rating Risks. Downgrades by Global rating agencies increases the risk perceived with the investment in Government bonds. As the rating drops, the investorsre-calibrate their yield requirement to discount for higher amount of risk. For example, if India is downgraded from Baa2 to Baa3 by Moody’s, there may be sell-off in Government securities leading to increase in Yields.

The other factors which determine these sovereign ratings are: Fiscal Deficit, GDP Growth Rate, Political Risks, Current Account Deficit, Inflation Rate, Forex Reserves, etc.

Therefore, Gilt Funds are exposed to various risks just like any other asset class which can impact its return over the short-run. 

Impact of current announcements on bond yields

The RBI reduced the repo by further 40 bps on May 22, 2020 to 4%. Since February 2019, the RBI has reduced rep rate by 250 bps from 6.5% to 4%. The reduction in repo rates should ideally lead to a further reduction in yields (as 10-year bond yields are at around 6%) and a rally in bond prices. However, therecent announcement by the Government with regards to market borrowings of INR 12 lakh crore (an increase of INR 4.2 lakh crore from its borrowing target announced in Union Budget 2020-21)will offset the impact of reduction in repo rate and limit the rally in bond prices. Higher bond issuances will ensure abundant supply of Government securities thereby reducing the possibility of a rally in existing bond prices. Also, the possibility of a downgrade by global rating agencies due to widening fiscal deficit on account of increased market borrowings may lead to expectation of higher yields, thereby leading to sell-off in existing bonds.

Invest in Gilt Funds with Investment Horizon of 5 Years

Gilt Funds are an excellent product for capital protection and to earn risk-free real positive returns (inflation adjusted positive returns). Therefore, the product is an excellent bet for investors with low risk appetite. Currently, India has its lowest ever repo rate at 4.0%. Though there is scope for a further drop by 25-50 bps as suggested by RBI’s ‘Accommodative’ stance, it is unlikely that the low interest rate regime will continue for a long period of time. Also, the higher market borrowings may further protect downside in the Government bond yields. This provides limited scope for a rally in bond prices.

The Gilt Funds can even generate negative returns over the next 12 months, if the interest rate direction reverses during the period. Therefore, it is not advisable for investors to look at gilt funds from a short-term perspective of 1 to 3 years. 

Gilt Funds is a good bet over FD for investment over long-term

The long-term capital gains tax (investment beyond 3 years) on Gilt Funds is 20% post indexation benefit. The indexation benefit (returns adjusted for inflation) is not available while investment in Bank FDs. Therefore, the effective tax liability is substantially lower for gilt fund investors as compared to FD. Longer the time horizon, the more superior would be investment in gilt fund as compared to FD. 

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