Investing in Gilts
Understanding Gilt Funds
What is a Gilt Fund?
Gilt funds are a type of debt funds which invest in fixed-interest generating securities issued only by the Central & State governments. This implies that our investments are directed towards government-funded infrastructure projects and other safe expenses.
Is it a low risk investment?
Gilt funds generally do not have credit risk since the issuer of the securities is the government. However, Gilt funds, like many other debt funds, have a high degree of interest rate risk, depending on their maturity profile.
What is Interest Rate Risk?
Interest rate risk is the potential for investment losses that result from a change in interest rates. Market prices of Gilt Funds (and all debt instruments) rise when interest rates fall. Gilt funds invest in government securities which have both short-term and/or long-term maturities. The longer the maturity profiles of the instruments, the higher the interest rate risk.
How are the returns?
When compared with a typical equity fund, a gilt fund offers better asset quality despite the relatively lower return it offers. These funds are still capable of generating returns as high as 12% or more. However, returns from gilt funds are not guaranteed and highly variable with the changes in the overall interest rates.
More Details
Measure of Interest Rate Risk
One need to have preliminary understanding of two Terms commonly used in Debt Market funds investment viz: Duration (Macaulay Duration) & Modified Duration
Duration: Duration (also known as Macaulay Duration) of a bond is a measure of the time taken to recover the initial investment in present value terms. In simplest form, duration refers to the payback period of a bond to break even, i.e., the time taken for a bond to repay its own purchase price. Duration is expressed over a number of years.
Illustration:
Taking a bond having 2 years maturity, and 10% coupon, and current price of ₹101.79, the cash flows will be (prevailing 2 year yield being 9%):
Duration in number of periods = 379.28/101.79 = 3.73
Duration in years = 3.73/2 = 1.86 years,
Duration in years = 3.73/2 = 1.86 years
Modified Duration: Modified duration (MD) is a modified version of Macaulay Duration. It refers to the change in value of the security to one percent change in interest rate (Yield). The formula is: Modified Duration = (Macaulay Duration) / (1 + YTM/n), Where YTM = Yield to maturity, n=number of coupon periods per year
Illustration
In the above example of Macaulay Duration, MD = 1.86/(1+0.09/2) = 1.78
Modified Duration, Interest Rate, Gilt Funds Value: Modified Duration is useful primarily as a measure of the sensitivity of a bond’s market price to interest rate (i.e., yield) movements. The modified duration is the approximate percentage by which the value of the bond (NAV) will fall for a 1% annual increase in market interest rate. So, a 15-year bond with a modified duration of 7 years would fall approximately 7% in value (NAV) if the interest rate increased by 1% annually. In other words, modified duration is the elasticity of the bond’s price with respect to interest rates. In general Modified Duration (MD) is more in case of Gilt Funds (in excess of 5 years) and thereby Gilt Funds are more sensitive to interest rate movement.
Fund Manager Role in Managing Interest Rate Risk: A traditional gilt fund invests in a mix of government securities with varying maturities. By actively shifting the duration of the portfolio, the fund manager seeks to make the most of interest rate movements. If he expects rates to soften, he may shift a large part of the fund’s corpus to government securities with 15–20 year or higher maturities. Conversely, if he expects the rates to rise, he may invest a higher portion in government bonds with 7–10 year or lower maturities. However, this leaves the gilt fund vulnerable to the calls of the fund manager. Constant maturity type of gilt fund invests in a mix of government bonds with maturity of around 10 years. Whatever the interest rate scenario, the fund’s portfolio duration is maintained at 10 years. Unlike traditional gilt funds, it takes a much more passive approach towards government bonds. It removes the element of human error — the risk of wrong duration calls by fund managers.
Gilt Fund Performance Examples & Analysis: I selected two funds and tried attempting to analyse keeping in mind principles discussed above.
1. Nippon India Gilt Securities Fund Direct Growth: This fund has given 10.82% annualized returns in the last three years. In the last year, its returns were 16.42%.
2. IDFC Government Securities Investment Plan (IDFC GS IP) Direct Growth: This fund has given 10.48% annualized returns in the last three years. In the last year, its returns were as high as 17.75%.
IDFC GS IP was further studied in detailed and correlated with RBI interest rate movement during last year and many past years as per following charts
Observation on underlying Principle that “the performances are highly dependent on the movement of interest rates”
Experts may opine that better performance of gilt funds in the last 1.5 years is driven by favorable interest rate cuts from 6.5% to 4.0%. But the above graphs show that this underlying principle on performance of Gilt Funds is not always true. NAV of IDFC GS IP fund increased from 25 to 27 between Dec 19 to March 20, Repo rate being the same. No drastic upward change in NAV seen due to drastic reduction in Repo from 5.15 to 4.4% in March end and now to 4% on May 20.
Fund Manager active switching from Low to High and vice versa maturity Govt. securities must have played a vital role.
Initially, I did the above analysis in Mid April 2020 with a view to start investing in Gilt Funds. However, I did not invest, in view of the high volatility of these funds. Since then I am tracking these funds. Looking at AMFI Gilt Funds data of April 2020 end which became available on May 20, huge interest of investors in Gilt Funds can be noticed from the fact that the number of folio and investment amount in April 20 has taken a drastic upward jump. Net inflow of more than Rs 2500/- Cr is far more as compared to any of the past 12 month. Number of portfolios increased by nearly 22000 or by 19%. Similar interest of investors can be seen during May 2020 as per the latest MF data made available on AMFI website on 8th June 2020. This interest in Gilt Funds is at a time when there is a huge outflow from many debt funds post Franklin episode of winding up of 6 debt schemes.
Key Takeaways
What are your financial goals?
One may consider investing in gilt funds for wealth accumulation over a medium-term to ride on the interest rate volatility. In other situations, when the overall capital markets are going downwards, and one is looking for safer havens to earn short-term returns, then gilt funds could be the right choice.
When to Invest?
As can be understood from the above discussion, it would be beneficial to invest in Gilt funds when the interest rates are falling. Also, when the economy as a whole faces a slump, Gilt funds are still expected to deliver higher returns than even equity funds. So, a falling interest rate regime would be the best time to invest in gilt funds. The economic outlook due to COVID-19 is a time when an interest rate decline was predictable.
Source: AMFI, RBI, Money Control, ET Money, Value Research, etc.
[Sole intention of the above article is to learn about Gilt Funds]
